Welcome to the jungle

It all goes back to those financial market tourists.

Today's missive will focus on factor investing despite the risk of turning this post into a post for factor wonks. Now factor investing is one of the many buzz words thrown around in finance, particularly on the trading floors that house most heavy brains or propellor heads, as I like to call them. There's a lot of inside baseball or assumed terminology, and ill do my best to explain along the way, but if you get lost, don't feel bad. You probably have a social life and don't take time out of your day writing about the anals of factor investing, which is nice. Truth be told, one of the reasons I've been dedicating more time to the site is because I have an egg chair and can benefit from being outside on my deck sipping an espresso martini while my puppy tears apart my backyard. Pandemic life makes you appreciate the little things. But enough about that, let's get to the meat of the potatoes. It may sound complex, but at the heart of it, factor investing is just an attempt to understand what drives asset prices, which sounds easy enough (LAWL). Once you know what drives asset prices, you can group securities into different cohorts and construct portfolios. In doing so, an investor can use these drivers, or factors if you've got a Ph.D., to manage long-term exposure to these drivers of returns and, in theory, outperform benchmarks. Of course, there are many applications of factor investing. For me, who likes to look at markets from a risk perspective, factor investing also serves as a critical mechanism for managing portfolio risk.

The size of the factor investing market is around US$ 3.4 trillion. Now given this topic is more of a technical topic, it might seem like a safe bet to shrug this post off as one of my rants on something niche no one cares about and leave it at that. However, although I can sympathize with you, I'd encourage you not to. There are tons of ETFs out there that use factor investing, and, frankly, you might own one without even knowing it. The market for factor investing has grown exponentially over the past decade, helped by the introduction of exchange-traded funds (ETFs). This easy access makes it possible for mutual funds, and even other ETFs, to own factor ETFs within their portfolio, making it hard for folks who don't know what they are looking for to know. Even if you understand factor investing, looking at stocks without a factor model to break down returns won't offer much value-add if you are interested in understanding where your portfolio's sensitivities lie. If I haven't made it clear yet, I am introducing this topic because I think there is something here for everyone, experienced or not, and I am presenting some tools over the coming posts to help the curious understand more.

Before we get too ahead of ourselves, let's understand why investors use factors. It doesn't sound crazy to think that understanding drivers of asset returns and gaining exposure to said drivers is something investors want to do. However, the need to do so has become far greater over the past decade because traditional asset classes (bonds, stocks) return far less than they used to. These lackluster returns are forcing investors to take on more risks to reach desired/required rates of return. As investors take on more risk, they need to find ways to manage it, and factor investing is just one of the tools they can use. There are many nuances here, and I think it would be helpful to refer folks back to a post I wrote a while back (pre-COVID when life was easier) that goes over the dynamics of searching for yield.

You shouldn't risk it for every biscuit.

We've all heard the saying you've got to risk it to get the biscuit. However, in financial markets, the question is more related to which risks are worth the biscuit. As it turns out, not all are, and that stems from the fact that some risks are diversifiable, meaning that investors have the power to diversify their portfolios. Cool, so let's talk about breakfast. Suppose you have a basket of 50 eggs you're planning to use over the next month. If you break an egg, it's not a big deal since you've got 49 more, and as such, you've reduced your risk of losing your morning omelet, barring some horrific event. However, all the eggs are still perishable and have a shelf life. In finance, that shelflife is the risk that deserves compensation, not the risk that you break one or two eggs because anyone that knows anything about finance knows all your eggs shouldn't be in one basket to begin with! Bringing this back to the world we're trying to understand; investors won't receive compensation for bearing company-specific risk over time but will be compensated for taking broader systematic risk. Factors help tease out systematic risks in the market so that investors can manage their exposure to them.

In short, anything can be a factor. Counterintuitive? Maybe. Remember when I said that investors needed to take on more risk to meet their desired rates of return? Well, one way to do this is through something called alternative risk premia. Now, to call a spade a spade, this is just a fancy way of saying stocks and bonds don't give me high enough returns, and I need to get creative to make money. But, of course, how investors do so varies considerably. So at this point, I think it's helpful to run through a quick but ludicrous example to showcase how factor investing can be used to "harvest" alternative risk premia.

I get pretty excited about asphalt shingle production. It could be because I am Portuguese, or maybe I am just trying to keep you from falling asleep. Either way, there's a series on Statscan that measures asphalt shingle production in Canada, and for some reason, I think this series would be a good driver of returns for the broader S&P500 (for the record, I don't believe this). I also feel that asphalt production will skyrocket, and I want to own some of that upside. Well, factor investing can help me out here. The first step is to find out which stocks in the S&P500 correlate to asphalt production. Then, I can construct a portfolio of stocks that buys the positively correlated stocks and sells the negatively correlated ones. This is a long-short portfolio, and by creating this portfolio, I am using a traditional asset, stocks, to gain exposure to asphalt shingle production (an alternative risk premium). Now I am using a ludicrous example to prove that anything can be a factor -- that doesn't mean that anything can work.

There's an important distinction between risk factors and risk premia. Not all risk factors have a risk premia, going back to the notion that not all risks are worth taking. Remember that a risk factor helps explain returns in assets, while a risk premium is the excess return we expect from the risk factor. So a risk factor can help explain returns in assets but can poorly deliver excess returns. Confusing eh? Let's jump back into an example. It's well known that stocks tend to behave similarly to other stocks within the same industry. For example, if oil prices move higher, Shell, Exxon, and Chevron will probably be up on that day. Therefore industry classification could be a risk factor that helps us explain why two stocks behave differently. However, we wouldn't expect to earn a risk premium because we can diversify away industry risks. The bread and butter of factor investing comes down to quantifying what can not be diversified (in theory) and finding out if they are worth the hassle. There are only a few common categories of factors in practice, and the secret sauce, like anything else in finance, is always in the details.

What are some common factors?

Factors come in two broad categories, macroeconomic and style. As the name would suggest, macroeconomic factors focus on drivers of economy-wide returns. An example of this would be economic growth or inflation. These factors are helpful because they can explain differences in performance across asset classes. For example, economic growth will likely positively impact commodity markets as demand for commodities increases. The opposite is true for bonds, as economic growth will prompt central banks to raise interest rates to quell inflationary pressures. This type of directional thinking is enough to inform single asset class decisions. Still, if you're running a multi-asset portfolio like most institutional investors are, you'll need to tie numbers to these estimates, and that's where a factor model comes in, which we will get into in coming posts.

Style factors help explain differences within asset classes. Now that we have a way to drill down into an asset class, how do we pick specific assets within that class? One solution is to use style factors to capture changes in risks, investor psychology, and market frictions. These factors range from buying companies that are performing well (momentum) to buying companies that have been performing poorly but are believed to have enough to turn things around (value). Others can look at the quality of the companies earnings or balance sheet (quality), and some look at investing in smaller, higher growth companies (size). Finally, we can look for companies that offer stable cash flows (carry/dividend) or filter assets by their volatility (volatility). How we define each of these factors is crucial to getting the basket of assets that we invest in, and later posts will dive into more detail on how we can define certain factors.

With that said, I figured it would be worthwhile trying to show how some of these factors have performed since the start of the year. The chart below shows the range of performance for a variety of different factor ETFs and mutual funds based in the US. The panels are ranked in order of worst-performing to best performing from left to right. Since the start of the year, we've seen the value factor outperform the other common factors. This is a stark departure from what we've seen in the past decade, where momentum and growth names have vastly outperformed. The reasons for this outperformance are beyond the scope of this post. Instead, we will detail in coming posts why certain factors have beaten others and why the pandemic has had a significant impact on how propellor heads view factor investing.

There is a lot to digest in these pages, and I think it's best to leave it there.

As always, thanks for reading,

Tiago Figueiredo