CEO's Corner

 

In this series our CEO Kenneth Smith shares his thoughts on finance and investing.

New Market Factors: A Look At Fundamental Index Investing

A key tenet of Empirical’s investment philosophy is that certain “factors” exist within equity markets that offer long-term risk-adjusted return premiums (or returns in excess of the market as a whole).  The specific factors used in Empirical models are the size premium (tilting the portfolio allocation toward companies with a smaller market capitalization) and the value premium (allocating more weight to firms with lower price-to-earnings or price-to-book ratios).  These size and value effects are often referred to as two of the three Fama-French1 factors.2  However, within the past year several fund providers (e.g., Charles Schwab, iShares, and Dimensional Fund Advisors) have created investment offerings based on new factors, using names such as quality, fundamentals, and profitability.  This article will examine these recently popularized factors and discuss how Empirical views multi-factor based strategies in an investment portfolio.

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Investment strategies based on various aspects of individual factors is a common and longstanding strategy among active fund managers. This approach has been around for decades. The significant change with the new wave of funds is that these fundamental screens are being applied to index funds (that is, passive funds).  Before analyzing these factors as part of an investment model, it is instructive to look at the wide range of equity characteristics that are considered in some of these strategies.  Schwab Fundamental Index Funds weight stocks by retained operating cash flow, adjusted sales, and dividends plus buybacks.3   The “quality” funds created by iShares grade assets on return on equity, stable year-over-year earnings, and financial leverage.4  Dimensional Fund Advisors (DFA) has added a “direct profitability” factor to many of its funds, which measures operating income before depreciation and amortization minus interest expense scaled by book value.5

An immediately apparent aspect of these new factors is that they each use a completely different set of equity fundamentals.  One would clearly want to understand the potential effectiveness of any of these approaches, and indeed if one is preferable to another.  Another question is why multiple fund providers have created factor-based offerings within a relatively short period, especially given that the underlying fundamentals on which these factors are based have been used in equity analysis for many years.  One potential answer is that a majority of investment product offerings are demand-driven, as opposed to having been recently discovered as a way to add value to the investment space.  As more and more investor assets flow into indexing strategies, fund companies have been striving to distinguish themselves from other passive investment providers. It may well be that this rash of fundamental-based indexing is a by-product of this need for differentiation.

More importantly though, than what has prompted their creation is the question as to how well these factors may perform.  The critical question is: Do they add value to an investment strategy?  Size and value are fundamental factors that have proven to be incredibly robust over time.  It is this consistency that we are looking for in any new investment strategy or asset class.  The quality, fundamental, and profitability factors have performed well in back-tested data, but it remains to be seen how they will do in the future, particularly as an investible strategy.  Designing a stock selection model that outperformed markets in the past is not difficult, but creating a strategy that will consistently outperform in the future has proven to be nearly impossible.  This is in part due to the phenomenon of market efficiency, where new information tends to be quickly acted upon, and thus factored into asset prices.  Market anomalies that would allow an investment strategy to outperform are rapidly capitalized on by market participants (such as professional traders, institutional investors, and, more recently, computer algorithms), and thus market beating opportunities quickly cease to exist.  In industry terms, this is referred to as the market inefficiencies being “arbitraged” away.6  The ability to continue to add value after decades of existing as a known strategy is what makes the size and value premiums so special, and is why these factors play a key role in Empirical investment portfolios.

At Empirical, our investment models are created by using high-level academic financial research (both theoretical and applied) coupled with a thorough analysis of market data.  We work to stay on top of new investment styles and asset classes, but we will not invest our client’s money in these strategies unless we feel very confident that they add value to a portfolio.  While the research on these new factor models is interesting, we prefer to monitor how each approach fares as investible strategies (as opposed to as theoretical models).  We are reserving judgment until further evidence is available.  If we conclude that any of the new factors add value either as a return enhancer or as a risk reduction tool, we will then determine how they fit into our investment portfolios.  Until that point, we will continue to retain our time-tested Targeted Premium strategies, adapting as markets change and evolve.  For more information about how our investment strategies are designed and operated, please feel free to contact us.

References
1. This is derived from the seminal 1993 article by Eugene Fama and Ken French.  The third of the three factors is correlation to the market as a whole.
2. It should be noted that there is a widely accepted fourth factor, discussed by Mark Carhart in his 1997 follow up to the 1993 Fama-French article.  This factor is momentum.  While momentum is persistent and economically significant, it is generally agreed in the financial literature that after accounting for trading costs and other market frictions, momentum is not an exploitable market premium.
6. This jargon refers to the aforementioned traders and trading algorithms, which often times attempt to profit via arbitrage, which implies making an instant riskless profit through a particular trade or set of trades.  Traders who operate this way are sometimes called arbitrageurs.

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About Kenneth R. Smith

Ken is the Chief Executive Officer of Empirical Wealth Management. He holds an M.S. in financial analysis and is a Certified Financial Planner®.

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