Factor Analysis & Traditional Asset Allocation

It might take a less than ideal investment philosophy and make it more ideal

Traditional research holds that most of a portfolio’s asset allocation explains its returns: namely, how much is in specific investment styles – small-capitalization stocks, large-cap stocks, growth stocks, value stocks, Treasury bonds, real estate investment trusts, etc.

But there are other drivers that help with returns too – and these go beyond conventional asset classifications.

Historical research shows that investment results also stem from certain factors that have outperformed the market over time. A factor is any characteristic a group of stocks shares that can explain their returns and risk.

There are a number of different factors that have historically determined a risk premium, which is the amount of return over a safe asset, typically U.S. Treasuries.

Understanding Factors

Notable among these factors are:

Value. Stocks that have low prices compared to their fundamental value – that is what they are worth given their earnings history and other attributes.

Size. Stocks with smaller market capitalizations.

Momentum. Those with higher price momentum, meaning they have been moving upward and likely will continue to do so.

Low Volatility. Ones that don’t gyrate as much as the overall market. This uses a metric called beta, which measures how the market’s moves tend to affect an individual security.

Quality. Stocks with low debt, stable earnings and other quality metrics.

Which Factors Matter?

Much speculation turns on why factor outperformance exists and whether it will persist. The reason some factors tend to outperform is easily grasped.

For example, the value factor is based on the notion that, if you buy something at a lower price and hold onto it for a long time, then it should do better than something you buy at a high price. To be sure, value stocks can be riskier than growth stocks, since they have a more uncertain future and markets compensate investors for taking more risk.

The size factor? Smaller stocks have more room to grow then larger stocks, although small companies usually suffer more in recessions because they are more vulnerable economically.

Momentum comes down to investor psychology. Investors tend to pile into whatever is going up, creating trends that persist, at least in the short-term.

The quality factor rests on the commonsensical idea that companies with strong financials should do better than those with weaker ones.

The low volatility factor is more debatable. While stocks that don’t rise or fall as much as the market seems to possess the virtue of steadiness, that doesn’t suggest a lot of upside for investors. They suffer less harm in downturns (maybe), but don’t benefit as much from the rallies (also maybe). And equities tend to rise more than fall over time.

Factor Analysis

For investors who still follow a traditional asset allocation approach, factor analysis presents a way to take what might be less than ideal investment philosophy and make it more ideal. Instead of trying to optimize portfolios exclusively by investment styles, you could increase your factor analysis.

Investment styles will still have factor exposure, but it will not be pure. For example, a market cap-weighted index of value stocks will still hold some stocks that are more blends between value and growth.

For practitioners of tactical asset allocation – which seeks to allocate assets according to market trends and exploit inefficiencies, among other dynamic moves – factor investing provides another powerful tool.

Historically, many tactical strategies have focused on style or sector rotation as a way to be positioned in the strongest style or sector. You can combine or replace this type of analysis with factor rotation, where the strongest factor determines how to shift your holdings.

Over time, factors have shown a great degree of cyclicality. Each factor generally has at least a two-year period of underperformance, versus market cap weighted indexes. But they are not completely correlated during a downturn, known as underwater correlation.

But if it’s true and factors can help drive stock market performance, then this factors-oriented strategy should do well, as it favors whatever factor is currently in vogue.

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