What are Factor Indices? An Independent Guide

Read our independent guide on investment factors. We use jargon free language to clearly explain what investment factors are and how they work. Click here for more details.   

Key Takeaways:

A factor index is a focused investible index that tracks various academically proven investment styles such as value and momentum. The rising popularity of factor indices is a direct response to the poor performance of asset managers and the weaknesses of market cap weighted benchmarks. Investors are also increasingly looking for a more tailored approach to investments based on their individual objectives. Factor indices have mostly been used in equities, though there are some nascent efforts to apply factors to fixed income.

There is now a plethora of factors, each claiming their own validity. Some fund and product providers will have you believe that factor investing is the answer to all your investing needs, and indeed factors exist precisely because of investors’ biases. Nonetheless, investors should remember that factors are not necessarily a sure thing or a quick win. In some cases, factors could experience years of underperformance with no guarantee on returns.

Introduction

Many of the world’s best-known indices, such as the Nasdaq 100, S&P 500, MSCI World and the Bloomberg Barclays Aggregate Index are benchmark indices. They are broad-based, passively run and typically market cap weighted, whereby the largest assets have the most weight. The downside with that is, the index’s performance will inevitably be led by the larger stocks, which usually lack the agility of the smaller stocks to propel growth. The phenomenon of the largest stocks outperforming other stocks over the past few years is an anomaly rather than a norm by historical standards.

Factor indices, on the other hand, are usually created as a sub-set of a benchmark index and aim to track more specific, more narrowly defined investment styles.

If a benchmark index could be thought of as a very large supermarket cart filled with everyday food items, a factor index would be a small hamper with specific items. For instance:

  • The quality factor might be organic-only food, i.e. superior quality, more expensive but is believed to be better for the body in the long run.
  • The value factor might be canned food that are on sale; they have a long shelf life and you stock up when they are cheap.
  • The momentum factor might be energy drinks and vitamin supplements which aim to improve your body’s condition.
  • The low volatility factor might be milk, bread and pasta – simple staples whose price rarely fluctuates.

Each of these food groups appeals to different consumers with different needs or desires, in the same way factors can meet different investor preferences.

In this guide, we will cover the major factors, the theories behind them, as well as their key benefits and pitfalls.

The Rise of Factors

To many, the birth of the factor revolution occurred in the early 1990s when two University of Chicago professors, Eugene Fama and Kenneth French formally identified equity value, market risk and size as the key anomalies (factors, or risk premia) that could affect investment returns in a positive way.1 In fact, factors have a long history in investing, value has applications dated as far back as 1779 when Abraham van Ketwich, a Dutchman widely regarded as the founder of the world’s first investment fund, launched a new mutual fund and stated that he would invest in “solid securities and those that based on decline in their price would merit speculation and could be purchased below their intrinsic values.”2

Nonetheless, the famed Fama French Three-Factor Model inspired a whole generation of economists to examine other factors. Momentum was added by Mark Carhartt3 in 1997, low volatility was championed by Andrew Ang and others in 2003,4  and Fama and French added quality to their original factors in 2014.5

While most of the factor research has been focused on equities, researchers have found that fixed income factors can also provide “consistently higher” returns over traditional bond benchmarks.6 

In recent years, factor indices have experienced a surge in popularity. Fans praise them as an effective substitute for active managers and, with their lower fees, better value for money. As a matter of fact, the April 2020 S&P SPIVA8 report (which tracks active managers’ performance versus indices) for the US all-cap category shows that over the past 12 months, 70% of the active managers failed to outperform their benchmarks. For large-cap stocks, it is 70% over one year and a whopping 89% over 10 years. In a US factor example, 97% of active value funds underperformed!

What are the Key Factors?

Although a prominent Duke University professor has identified over 300 potential factors9, we believe our readers should only consider factors supported by solid academic research and broad acceptance to avoid sub-optimal results. Below we discuss the core academically validated factors that have been applied to widely available indices. Readers can also find further information on each of them in our library.

The value factor exists because fast-growing stocks get investors excited and their “fear of missing out” buys keep pushing the share prices up until the stocks becomes overvalued. On the other end of the scale, the old, stable stocks attract a lot less interest, become cheaper and fundamentally attractive. Over time, investors can profit from purchasing these relatively cheap stocks. Value in stocks can be expressed through fundamental ratios such as price to earnings (also cyclically adjusted), book to market, dividends, buy back yield and total yield. For fixed income assets, credit spread (vs. fundamentals), leverage and profitability can be used.

Momentum is the phenomenon where past winners keep on appreciating. This is because they tend to attract attention and frequently there is a story or narrative that drives investor interest. As more investors buy into the narrative, demand for the stock grows which pushes the price even higher. Momentum may also exist as a result of investors’ delayed reaction to news. Momentum metrics can examine the price performance of the asset over the past three, six and 12 months.

Low volatility, or low risk, tends to exist because institutional investors often cannot explicitly obtain leverage, so they prefer high beta stocks to obtain greater market exposure. Beta is a measure of the amount of movement for a stock relative to the overall market. Low beta stocks, or low volatility stocks, tend to get less attention from investors, so they are typically cheaper and may outperform in the long run. Low volatility metrics typically examine past volatility to optimize a basket to produce a low volatility portfolio.

The quality factor exists because profitable companies with strong balance sheets, low asset growth and quality earnings tend to outperform companies with excessive leverage, high investment needs and poor earnings. Quality can be expressed through the following ratios: high return on assets, potentially indicating efficient use of assets; low earning accruals, potentially indicating high quality earnings and low operating leverage.

Size targets a core tenet of investing that investors require higher returns to compensate for greater risks, typically found in smaller stocks or corporate bonds. For equities, the size factor can be accessed by purchasing small- and mid-cap stocks. The same principle applies to fixed income as market value weights of the bond can be used.

Benefits and Usage of Factors in Indices

At The Index Standard, we believe that factor indices are a very useful addition to an investor’s toolkit as they allow for more precise exposures based on individual needs. A cautious investor may allocate a large amount to quality or low volatility indices, whereas a bold investor may prefer more exposure to momentum. Pension funds can also use a combination of factors to maintain a balanced portfolio.

Besides being (typically) cheaper than active managers when purchased in an ETF, readers also have the peace of mind that there will be no style drift with a factor index. If you purchase a value index, you will always receive returns from the value premium. If you buy into an active value fund, however, you may discover later that the portfolio manager has purchased growth stocks or put a large allocation to cash, diluting returns from the value premium.

Pitfalls of Factor Investing

Factors are not a short cut to positive investment returns! They exist because of investors’ biases, and sometimes factors can experience years of underperformance as investment cycles play out, with no guarantee for a bright future. Value, for example, has not performed well in the past few years because investors have been in favor of growth stocks. It may take as long as 15 years for each style to peak before reverting to the average. Readers who are interested in factor investments may have to prepare themselves to play the long game.

References

  1. Eugene F. Fama & Kenneth R. French, Common Risk Factors in the Returns on Stocks and Bonds, 33 J. FIN. ECON. 3 (1993).
  2. Financial Market History. Reflections on the Past for Investors Today. CFA and Cambridge University. Chapter 12, K. Geert van Rowenhorst.
  3. Carhart, M. M. (1997). "On Persistence in Mutual Fund Performance". The Journal of Finance.
  4. The Cross?Section of Volatility and Expected Returns” Andrew Ang, Columbia Business School, Robert Hodrick, Columbia Business School Yuhang Xing, Rice university and Xiaoyang Zhang, Cornell University, Journal of Finance, July 2003.
  5. A Five-Factor Asset Pricing Model, Eugene F. Fama, University of Chicago, Kenneth R. French, Dartmouth College. September 2014
  6. Factor investing in the Corporate Bond Market, Robeco, Patrick Houweling and Jeroen van Zundert Financial Analysts Journal, Spring 2017
  7. Evaluation of Active Management of the Norwegian Government. Andrew Ang, Will Goetzmann and Schaefer (2009)
  8. https://us.spindices.com/spiva/#/
  9. “A Census of the Factor Zoo.” Campbell R. Harvey. Duke University - Fuqua School of Business. Yan Liu, Purdue University; Texas A&M University, Department of Finance. 25 Mar 2019

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