Effective Factors: Can You Differentiate Products?Tuesday 12th September, 2017
Style Research applies six criteria to identify a factor framework for effective fund identification, comparison, and research. In this next post in our “Effective Factors” blog series, we take a deeper look at how an effective factor framework can help differentiate products in a more insightful way.
More investors are tuning in to the potential merits of factor investing and extending their investment thinking and fund selection to consider style categories such as quality, momentum, and volatility, alongside the more traditional styles such as value, growth, and size. An obvious question springs to mind.
Why are we still using style boxes that partition funds into Large Value, Mid Blend, and Small Growth type categories?
Retiring the Style Box
The simplicity of a 3 x 3 type of partitioning of funds is certainly appealing. But the style box is too blunt a tool for current investment products and the need to assess them correctly and fairly.
Looking at funds within a style box category such as Large Value doesn’t leave much room for differentiation, beyond fund returns or fees, unless we then apply a new tool or framework of assessment. We illustrated this in a recent case study of three US Large Value funds. By expanding the palette of style categories to a more contemporary set that includes all of value, growth, quality, size, volatility, and momentum, we were able to distinguish between three funds labelled as Large Value. But the style distinctions were not just because of the extra style categories. They were also because of specific factor biases within these categories. With the advent of smart beta products, we hear more about style “factors” such as value and quality. However, we prefer to describe those as style categories rather than factors since the underlying factor choice within these categories can and does vary. These differences matter. For almost 20 years, Style Research has been proclaiming the importance of factor choice within style categories. We know that different types of value factors can perform quite differently. Examine the underlying methodologies of smart beta value products and you will see a myriad of definitions as to what constitutes value. And the differences are even more eclectic when it comes to a style category such as quality. An independent factor assessment framework should recognize these differentiators.
There’s more to fund differentiation than extending style categories or refining factor selection. These rarely surface because the focus is usually on style or “factor” labels. Attention also needs to be paid to portfolio structure, such as of sector and country weights. These can dramatically affect an analysis using style factors. Furthermore, diversification or portfolio risk is intrinsic to style or factor assessment, yet risk gets relegated to a separate discussion or ignored in most style assessments.
The Hidden Dimensions of Style Analysis – Portfolio Structure and Diversification
Portfolio Structure: Sectors and Countries
Are all technology stocks growth stocks? Of course not. The legendary economist, investor, and educator Peter Bernstein said, “a firm cannot become a growth company by association.” Are all stocks in the financials sector value stocks? Of course not. But in order to keep equity indices tractable and simple we are used to sectors being voted “with the styles.” This means that funds can often be classified as having style attributes that might just be byproducts of decisions to over- or underweight sectors. A similar issue applies to countries where an additional complexity of cross-border accounting differences causes yet another wrinkle. So any practical factor framework should take care not to automatically conflate sectors or countries with style.
What’s portfolio risk or diversification got to do with style? Style is intrinsically a diversified concept. A portfolio of 20 stocks with the same high dividend yield as a 200 stock portfolio may be less likely to outperform when high dividend yielding stocks perform well. Investors are more concerned than ever about paying active fees only to receive index-like returns from a closet index fund. A factor framework needs to differentiate between the active risk of funds as well as the style or factor biases. And active risk measures should also extend beyond active share which implicitly ignores common factors between stocks – the very thing a factor framework needs to measure!
More Criteria for an Effective Factor Framework
A judicious choice of style categories and the right factors within those categories is key to enable clear, detailed comparisons between investment products so that funds can be evaluated on an “apples-to-apples” basis. The factor framework for doing this must also integrate other aspects of portfolio construction including sectors, countries, stock concentration and a bona fide assessment of the active risk of the portfolio versus a benchmark.
This allows fund sellers and asset owners to understand the critical differences between funds, even those that appear highly similar on the surface.
Our series of criteria for an effective factor framework will continue in this month of September, next covering how to be selective with factors to avoid confusion and to provide a standard for fund comparison.
Author: Bernie Nelson | Categories: Portfolio Analysis
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