In the previous post, we saw that certain ‘factors’ or ‘risk premia’ can predict equity portfolio performance over and above the market factor. That is, using the knowledge of certain factors and tilting your portfolio to contain more of such factors, can help to improve performance over the market (or index fund) portfolio.
Willy nilly, all equity portfolios tilt towards some or the other factor. Once we examine the useful factors, I will give examples in the following posts of how these factors can be used, or how you can take a portfolio (say a portfolio owned by a mutual fund), and see what factor tilts the portfolio manager has created, even if unconsciously.
Six factors have stood the test of time, are popular, and have both risk-based and behaviour-based explanations for their performance. These are A) Size-small stocks give better results than large stocks B) Value-stocks with high ‘value’ give better returns than stocks which represent low ‘value’. C) Momentum-stocks which are moving higher continue to give better returns for a certain time than stocks which are moving lower. D) Low Risk-Stocks with low risk give better returns than stocks with high risk E) Quality-Firms which have higher quality give better stock returns than firms with poor quality and F) Investment- Firms which tend to invest low amounts give better stock returns in time than firms where large amounts of money are needed to be invested.
Table 1 summarizes these six factors, and also provide an explanation for why these factors ‘work’ to give higher stock returns. These explanations are often a subject of academic debate. This debate need not concern us, but a risk factor with a strong risk-based explanation is more likely to continue to have a premium in the future. It is more reassuring for an investor to have a risk-based explanation. In an efficient market with rational investors, systematic differences in expected returns should be due to differences in risk. Sometimes, its not about risk. Behavior of participants in equity markets often deviates from rational choice in the short run. The best factors are perhaps those which have sound risk-based and behavior-based explanations.
| Factor | Factor Definition | Risk-Based Explanation | Behaviour-Based Explanation |
| Size | Stocks with low market cap versus stocks with high market cap | Low Liquidity needs to be compensated by higher returns | Small-Cap stocks don’t attract sufficient investor attention |
| Value | Stocks with high book-to market versus stocks with low book-to-market | High sensitivity to shocks during stressed economic conditions | Overreaction to bad news and extrapolation of the recent past leads to subsequent return reversal |
| Momentum | Stocks with high returns over the past 12 months omitting the last month versus stocks with low returns | Stocks with very high recent performance are more sensitive to sudden price falls during economic shocks | Investor overconfidence and self-attribution bias leads to returns continuation in the short term |
| Low Risk | Stocks with low volatility of returns versus stock with high volatality | Low volatility in prices leads to investors using leverage which needs to unwound during periods of economic shocks | |
| Quality | Stocks of firms with high quality (e.g. return on equity) have high returns | Investors do not distinguish sufficiently between growth with high quality and growth with low quality, leading to under-pricing of quality growth firms | |
| Investment | Stocks of firms with low investment (e.g. change in book-value) have high return | Low willingness to invest leads to these funds shying away from capital intensive projects | Investors under-price low investment firms due to expectation errors |
Some caveats here. The factor definitions are themselves not written in stone. These do vary. For example, we ourselves will examine two other definitions of momentum, and indeed, one of the other definitions gives better returns than this one. Sometimes, one can take a few definitions and combine them into an overall factor score. For example, quality can be a combination of high Return on Equity and Low Leverage. Please wait till we examine each factor in detail for the full details of the definition.
Now that we have seen what factors are, and the common types of useful factors, we can now examine individual factors a little more in detail in the next post.