Why Factor Tilts Make Sense and Implementation Differences Matter

A reprinted article from July/August 2018

By Daphne Y. Du, PhD, CFA®, and Dan Price, CFA®, FRM®

Why Factor Tilts Make Sense and Implementation Differences Matter

By Daphne Y. Du, PhD, CFA®, and Dan Price, CFA®, FRM®

t is hard to read, watch, or listen offer better risk-adjusted returns than factor tilt strategies: the aim to capture to financial media today without a market-cap weighted index, and tilts persistent risk premiums associated with Ifinding references to factor tilts, offer opportunities to tailor portfolios to well-researched stock attributes, and the smart beta, scientific beta, and style meet specific risk and return objectives. use of transparent, systematic, and rule- or factor investing. We refer to all of based implementation with large these as factor tilts because there is Although the term “factor tilt” is relatively liquidity and capacity. These strategies no agreement on common definitions new, the concept of factors is familiar to are usually long-only, without deriva- for these terms and it is not the label many investors. From the most well- tives or leverage, and they often deviate but the strategy design that matters, known market factor of all, beta, which from a market-cap weighting scheme. e.g., choice of factors and how factors was described in the capital asset pricing Our goal is to explain why factor tilts are translated into portfolio weights. model (CAPM) (Lintner 1965; Mossin make sense and to highlight important Significant assets have flowed into 1966; Sharpe 1964; Treynor 1961) to the portfolio construction details. strategies under this theme in pursuit of value and size factors vetted in the semi- simple, transparent, systematic sources nal paper by Fama and French (1993), FACTOR TILT LANDSCAPE of return beyond traditional market-cap factors have become a common means of In the past few years, factor tilt strate- weighted indexes. Through a factor lens, describing a strategy’s exposures. The gies have brought in billions of dollars each security has an array of exposures Fama-French three-factor model paved due to the popularization of factor that explain its risk and return. Altering the way for Morningstar’s style box: a investing and the tremendous growth of factor weights from those in a market- nine-square grid based on size (large, the exchange-traded fund (ETF) indus- cap weighted portfolio—a “tilt”—can mid, and small) and fundamental style try in general. The ETF industry is a solve for two significant drawbacks of (value, blend, and growth) introduced in good gauge of the evolution of factor tilt a market-cap weighted approach to 1992 and still featured prominently in strategies for two reasons: (1) ETF data portfolio construction: concentration portfolio construction today. is readily available and not subject to the and undesirable factor exposures. reporting delays that are typical for Tilting toward rewarded factors while We adopt a broad definition that cap- mutual funds, and (2) the ETF industry diversifying away unrewarded risks may tures both “what” and “how” aspects of has its root in passive indexing, and

Table U.S. LISTED EQUITY ETFS 1 Index Weight AUM (Millions) AUM (%) # of Funds Three-Year Net Flow ($millions) Dividend $94,910 3.3% 61 ($5,171) Equal $77,248 2.7% 132 $18,957 Fundamentals $42,921 1.5% 81 $14,484 Market Cap (Growth/Value) $325,176 11.3% 39 $70,225 Multi-Factor $124,057 4.3% 242 $50,398 Proprietary $15,185 0.5% 122 $7,255 Market Cap (passive index) $2,165,013 75.2% 639 $544,686 Others $34,730 1.2% 100 $10,602 Total $2,879,241 100.0% 1,416 $711,436

Source: Internal calculation based on data from Bloomberg as of March 16, 2018. Categories other than “Market Cap” (passive index) and “Others” are considered smart beta.

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almost all products track a published Figure U.S. LISTED EQUITY ETFS LAUNCHED index. The index construction is typi- 1 cally transparent and rule-based, which is consistent with our definition of a factor tilt strategy. We rely on index weight and fund name to identify factor tilt ETFs. If “index weight” is Dividend, Equal Weight, Fundamentals, Multi-Factor, or Proprietary, or if “index weight” is Market Cap and fund

name has “Value” or “Growth” in it, a fund is considered a factor tilt fund. Of the ETF ETF more than 1,400 equity ETFs listed in the Source: Internal calculation based on data from Bloomberg as of March 16, 2018. Categories other than “Market Cap” United States, 50 percent of funds and (passive index) and “Others” are considered smart beta. 25 percent of ETF assets under management are now in the factor tilt category, Table FAMA-FRENCH FIVE-FACTOR PLUS MOMENTUM and more than 20 percent of ETF net 2 inflow over the past three years was into (A): Annualized Return and Risk: July 1963−January 2018 factor tilts (see table 1). In addition, over Size Value Profitability Investment Momentum the past five years, more than 60 percent Annualized Return 2.9% 4.1% 3.0% 3.4% 8.0% of the new ETFs that were launched were Annualized Risk 10.5% 9.7% 7.7% 6.9% 14.5% factor tilt funds (see figure 1). Given the Sharpe Ratio (SR) 0.28 0.42 0.39 0.49 0.55 growth in factor investing and the hun- Max Drawdown −29% −32% −28% −15% −83% dreds of strategies to choose from, it is (B): Factor correlation: July 1963−January 2018 important to have a solid understanding of what factor investing is trying to cap- Value Profitability Investment Momentum ture and how to compare strategies. Size −0.07 −0.35 −0.10 −0.03 Value 0.07 0.70 −0.18 FACTORS Profitability −0.03 0.11 A factor can be any characteristic that Investment −0.02 explains the risk and return of a group of Source: Internal calculation based on data from Fama-French’s research library at http://mba.tuck.dartmouth.edu/pages/ securities. The most compelling factors faculty/ken.french/data_library.html are those with plausible explanations, those with explanatory power that is is often cited as the father of growth factor, and an abundance of research significant and expected to persist, and investing. Price’s eponymous firm, suggests momentum exists in many those that offer a premium relative to founded in 1937, has built its investment asset classes and markets (Asness et al. a market-cap weighted alternative. process around a focus on earnings 2013). Banz (1981) first identified size Fundamental and technical equity fac- growth with a long investment horizon. as a factor found in small-cap stocks tors have received the most attention Academic factor research also dates that carry a premium. Novy-Marx and will be our focus. Fundamental back many decades. Ross (1976) popu- (2013) made one of the first cases active managers were responsible for larized the term “factor” in his work on for profitability as a factor. Novy-Marx some of the earliest work on value and arbitrage pricing theory. Ross (1976) measured profitability as a ratio of a growth factors. Benjamin Graham and challenged assumptions made in CAPM firm’s gross profit (revenue minus David Dodd are credited with establish- and laid out the idea that multiple fac- cost of goods) to its assets, and found ing the discipline of value investing. tors explain the risk and return of this factor had an ability similar to the Their influential work,Security Analysis securities without specifying an exhaus- ratio of book value to market value to (Graham and Dodd 1934), suggested tive list of what those factors might be. explain the variability of equity returns that buying equities at a discount to This opened the door for empirical stud- as well as a return premium. This their intrinsic value would provide a ies on the efficacy of various factors. profitability factor also has been margin of safety and suggested screen- referred to as quality. ing stocks on low price-to-book value Jegadeesh and Titman (1993) and and low price-to-earnings ratios as a Carhart (1997) found evidence of return A standard way to evaluate a factor’s risk means to preserve capital. T. Rowe Price premium associated with a momentum premium is to construct a portfolio that

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Figure FACTOR CUMULATIVE RETURN—JULY 1963−JANUARY 2018 for example by discounting resulting 2 risk-adjusted returns by as much as 50 percent. Instead, we recommend investing in factors that have proven to generate consistent risk premiums over time and across markets and have a solid economic foundation.

PORTFOLIO CONSTRUCTION Most discussions about factor investing stop at the point when a factor risk premium is documented. However, theoretical factor portfolios may not be R A directly investable. They do not control Source: Internal calculation based on data from Fama-French’s research library at http://mba.tuck.dartmouth.edu/pages/ for risk (such as industry risk), transac- faculty/ken.french/data_library.html tion costs (fixed and market impact of buying and selling securities), and taxes is long the top X percent, such as top drawdown of 82 percent. Research has (short-term or long-term capital-gain quintile, of factor-ranked stocks and shown that momentum tends to perform taxes from turnover), which are practical short the bottom X percent, such as well in “normal” environments, but it considerations for investors. There are bottom quintile by factor rank. The does not work well at inflection points broadly two ways to implement factor long-short portfolio removes systematic such as sharp rebounds or corrections. insights: long-short and long-only. A risk and highlights the return from the Past literature has suggested using mar- long-short portfolio can extract a purer factor in focus. We examine the latest ket sentiment or VIX (or both) to predict form of a factor premium because it five-factor model from Fama and French the turning point or forecasting momen- removes market beta and maximizes the in table 2 and figure 2. tum mean return and variance to spread between top- and bottom-ranked dynamically adjust momentum (Daniel stocks. It serves the needs of certain Using 55 years of backtest, Fama and and Moskowitz 2016). In practice, it is institutional investors or sophisticated French (2015) showed that size, value, challenging to time the turning point. individual investors. Long-only factor profitability, and investment factors have Portfolio managers need to understand tilt strategies include market beta and generated positive risk premiums and the economic drivers of factors and be may have relatively low tracking error to Sharpe ratios ranging from 0.28 for size cognizant of their performance cycles. market-cap weighted indexes. We focus to 0.49 for investment. The two newer on long-only investing because most factors, profitability and investment, per- Fama and French took more than 20 mutual funds and ETFs are long-only form comparably to value. Value and years to move from their three-factor and individual investors may be more investment have a high correlation of model (1993) to their five-factor model comfortable with long-only portfolios. 0.7, which Fama and French (2015) (2015). But today people talk about pointed out makes value redundant if libraries with hundreds of factors. Given Albert Einstein said, “Everything should the goal is to measure portfolio abnor- the power of computers and the avail- be made as simple as possible, but not mal return using their factor model. ability of data, it has become relatively simpler.” This applies to factor investing However, if used to measure portfolio easy for anyone with programming skills as well. Factor tilt strategies aim to fol- tilts toward these factors, inclusion of all to mine data and engineer factors. These low a transparent and rule-based five factors may be optimal. Lo and Patel statistically mined factors have beautiful approach, but craftsmanship matters. (2008) detail results in both a long-only backtest results, otherwise they would Portfolio managers need to make many and 130/30 format for portfolios con- not be presented, but out-of-sample choices: investment universe, risk target, structed with 10 factors. performance is arguably the only true portfolio weights, combining multi- test. Harvey and Liu (2018) suggest that factors, etc. Every decision influences Consistent with findings from earlier traditional statistics, such as t-statistics portfolio returns and risk. In table 1, the research, momentum generates the and p-values, used to evaluate the multi-factor group alone, including both highest risk premium (note it uses the significance of trading strategies are single- and multi-factor products, has right axis in figure 2) and is the most no longer valid if hundreds or even 242 ETFs, and the majority of them track volatile factor. It had a massive draw- thousands of backtests are conducted. a version of a factor index. It is import- down in 2009, with seven months of Backtests built on data without theory ant for investors to look under the hood negative returns and a full-year should be held to a higher standard, and understand different methodologies.

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Table INDEX COMPARISON 3 Eligible Universe Value Definition Portfolio Construction Weighting Schema Forward price to Calculate individual variable Z-score; MSCI USA earnings, enterprise take the average of three Z-scores as Proportional to market Enhanced MSCI USA value to operating cash composite score; derive sector relative cap X final value score Value Index flow, price to book Z-score from the composite value score Price to book, I/B/E/S Calculate individual variable Z-score; Proportional to market Russell 1000 medium-term growth Russell 1000 weigh the three scores by 2:1:1 to cap X composite Value Index forecast, sales per share compute the composite value score value score five-year historical growth Calculate individual variable Z-score; Proportional to market S&P 500 Price to book, price to S&P 500 take the average of three Z-scores cap X composite Value Index earnings, price to sales as composite value score value score Russell RAFI Break the link between prices and portfolio Sales, cash flow, book Fundamental U.S. Large Russell 1000 weights; use fundamental measures of value, dividends weighting Company Index company size to weigh securities

Note: Refer to each index provider’s website for a more complete description of index methodology. INDEX CONSTRUCTION Figure CUMULATIVE EXCESS RETURN OF VALUE INDEX VS. We use four well-known U.S. large-cap 3 PARENT INDEX value indexes to illustrate the impact of portfolio construction: MSCI USA Enhanced Value Index, Russell 1000 Value Index, S&P 500 Value Index, and Russell RAFI U.S. Large Company Index. They are not necessarily the

best—and they are certainly not the only—value indexes, but billions of assets track these indexes. The detailed

index methodology is publicly available and table 3 summarizes it briefly. E R R RAF U Figure 3 shows the cumulative excess Source: Internal calculation, data is from Bloomberg, February 1999 – January 2018 return of each index relative to its market-cap weighted parent index. the criticism that market-cap weighted exposure to those factors. All four indexes Different parent indexes are used to cap- indexes overweight overvalued securities. have negative exposure to momentum, ture the impact of different universes. which makes sense because value and MSCI USA Enhanced Value outperforms Factor exposure and risk analysis is a momentum are negatively correlated. its parent MSCI USA index by useful tool for looking under the hood of S&P 500 value and Russell 1000 value 3.1 percent per annum with tracking different factor tilt strategies. A long- indexes have more bias toward large-cap error (TE) of 6 percent, and Russell only factor tilt portfolio likely has securities than the other two. It is import- RAFI U.S. Large Company outperforms exposure to factors other than the ant to look beyond the branding of a Russell 1000 by 2.4 percent per annum intended factor tilt. A more accurate way factor tilt strategy to appreciate the with TE of 5.3 percent. Russell 1000 to measure exposure is to use holdings impact of difference in implementation. Value and S&P 500 Value have almost and an equity risk model. Alternatively, A careful review of portfolio construction, no outperformance over their respective we use the Fama-French five-factor factor exposure, performance attribution, parent indexes with TE close to model plus momentum to run return- and risk decomposition can illuminate 5 percent. If an investor invested in one based analysis. Figure 4 shows the how implementation differences might of these four indexes to tilt toward the exposures from a full sample regression yield different risks and returns. value factor, the investor would have had of index returns over factor returns. a very different experience after 20 years INTEGRATING VS. MIXING FACTORS depending on the index selected. Non- All four indexes have strong exposure to Although evidence indicates that factors market-cap weighted MSCI USA value, which is the desired factor tilt. outperform the market over long periods Enhanced Value and RAFI indexes out- They also all have positive exposure to and there are economic rationales for performed the two market-cap weighted profitability and investment, though why many factors might persist, each value indexes, which is consistent with RAFI stands out with especially high factor has gone through periodic bouts

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Figure FACTOR EXPOSURE TO FAMA-FRENCH FIVE FACTORS AND MOMENTUM 4 Size Value Profitability Investment Momentum R UA E R RAF U

Source: Internal calculation, factor return is from Fama-French website, index return is from Bloomberg, February 1999–January 2018

of underperformance. The periodic COV: variance-covariance matrix of is based on the ranking from one factor. underperformance of individual factors securities For a multi-factor portfolio, Zi would be may extend beyond a client’s investment a composite of different factor rankings, horizon and can present a significant TCAF: transaction cost amortization fac- such as the average of a momentum fac- drawdown risk. Hence, investors should tor, a scalar tor Z-score and a value factor Z-score. consider combining factors for diversifi- cation. Here we discuss two common TC(Δh): vector of expected transaction In the case of mixing, h will be the choices for building multi-factor portfo- cost on the trading list average holding from stand-alone lios: integrating versus mixing. optimizations that consider one factor Taxes: federal and states taxes due for at a time. Each optimization will over- Mixing factors refers to first building realized capital gains weight securities with the highest single-factor portfolios, i.e., define the ranking in a particular factor as much as investment universe, decide on security The first termh’*E(r) represents possible while meeting constraints. As a weights based on individual factors, and expected return, the second term λ * h’ result, the mixing portfolio is likely to then combine the weights from single- *COV* h represents penalty on expected have polarized positions that rank high factor portfolios. Integrating factors risk, the third term TCAF * h’*TC(Δh) in individual factors and miss securities refers to the practice of integrating stock represents expected transaction cost on that are not ranked the highest in a par- rankings of different factors into one trading, and the final term Taxes rep- ticular factor but have overall good composite ranking, which is then used resents taxes due as a result of realized exposure to a few factors. In the case of to derive portfolio weights. gains or potential savings from tax loss negatively correlated factors, polarized harvesting. positions could even offset each other. A mean-variance representation of From an optimization theory point of building a factor tilt portfolio is shown in There are different ways to transform view, a mixing approach is inferior to equation 1: security rankings to portfolio holdings. the integration approach because it sees One approach commonly used in quan- only the local optimal, not the global Maximize { h’*E(r) – λ * h’ *COV* titative portfolio construction is to optimal. In the case of integrating, the h – TCAF * h’*TC(Δh) – Taxes } (1) translate rankings to expected returns portfolio will balance the views from and use optimization to solve for hold- different factors and consider risk, h: vector of portfolio weights ing weights. Grinold and Kahn (2000) transaction cost, and taxes holistically. proposes the following linear Fitzgibbons et al. (2015) simulated value h’; the transpose of vector of portfolio transformation: and momentum strategies assuming a weight −0.6 correlation between the two factors. E(ri ) = IC * Volatilityi * Zi (2) They found that an integration approach Δh: vector of trading list as a result of adds 1 percent per annum excess return portfolio rebalance E(ri) is the expected return for security I, and a 40-percent improvement in infor- IC is information coefficient,Volatility i mation ratio over a mixing approach. E(r): vector of expected return is the expected volatility for stock i, and The benefit comes from higher exposure Zi is the standardized Z-score for each to factors, and the benefit is larger when Λ: risk aversion parameter, a scalar security. For a single-factor portfolio, Zi blending factors that are more

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Table MULTI-FACTOR AND SINGLE-FACTOR INDEX RISK AND RETURN 4 Enhanced Value Quality Momentum Risk Weighted Multi-Factor Index Mixed Index Annualized Return 6.30% 7.25% 9.50% 9.19% 9.51% 8.18% Annualized Risk 14.62% 13.76% 15.39% 13.35% 14.80% 13.43% Sharpe Ratio 0.43 0.53 0.62 0.69 0.64 0.61

Source: Internal calculation. Data is from MSCI, February 1999–January 2018

Figure INTEGRATING VS. MIXING CUMULATIVE PERFORMANCE 5 F EBRuary 1999–JANUARY 2018

E R F

Source: Internal calculation, factor return is from Fama-French website, index return is from Bloomberg, February 1999–January 2018

negatively correlated. An integration single-factor indexes because it is a market impact. U.S. large-cap equities approach also was found to reduce one- simple average of the four. The multi- are among the most-liquid stocks in the sided turnover by 10 percent. factor index has similar return to the world, and one-way cost is typically in momentum index and outperforms the low single-digit basis points during Using MSCI indexes to illustrate the the other three single-factor indexes normal times. When a lot of trades driven impact of integration and mixing, because it synthesizes the merits of by the same factors might take place at table 4 and figure 5 compare MSCI individual factors and achieves more the same time (i.e., market close on an USA Diversified Multiple-Factor Index desirable factor exposures over time. index rebalance day), the cost could be (integrated) versus mixing four stand- Sharpe ratio is close between the multi- higher. Moreover, cost ramps up quickly alone factor indexes (MSCI USA factor index and the mixed index as the when trading small-cap and international Enhanced Value, MSCI USA Sector former takes on more risk than the latter. equities and fixed income securities, such Neutral Quality Index, MSCI USA as corporate bonds. Momentum Index, and MSCI USA Risk TRANSACTION COST Weighted Index). The MSCI USA A practical consideration in managing When investors evaluate factor tilt strat- Diversified Multiple-Factor Index factor tilt strategies is transaction cost. egies, it is important to look at rebalance equal-weights factor exposure for the Whenever there is turnover, the portfolio methodology, because of the link four target factors—momentum, low will incur transaction costs, including between rebalancing and turnover and size, value, and quality—and uses the commissions, exchange fees, stamp duty, transaction costs. For the four value composite score to determine each and market impact. Market impact is a indexes discussed earlier, Russell RAFI security’s weight. The multi-factor hidden cost that most investors under- U.S. Large Company Index has the low- index outperforms the average of the appreciate; it is due to the demand for est turnover, 11 percent per annum, and four single-factor indexes (hereafter liquidity and is usually a function of trade rebalances once a year. Russell 1000 referred to as the mixed index) by size, stock volatility, and liquidity (aver- Value Index has double the turnover and 1.3 percent per annum. The perfor- age daily volume, bid-ask spread). Trades rebalances once a year. MSCI USA mance of the mixed index is in the with larger size, in less liquid and more- Enhanced Value rebalances twice a year middle of the rank among the four volatile securities tend to have higher and has a turnover of about 15 percent.

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S&P 500 Value Index rebalances annu- investors seeking to harvest factor pre- insights, such as value, momentum, ally and has a turnover of about miums should consider employing growth, and profitability, from active 15-percent. Momentum strategies active tax management. Bergstresser management. Investors might reason- inherently have much higher turnover. and Pontiff (2013) pointed out that ably demand outperformance from MSCI USA Momentum Index rebalances small-cap and value strategies tend to active management to compensate for twice a year and has more than have higher capital gain realization than fees in excess of both passive and sys- 100-percent turnover. MSCI USA large-cap or growth strategies as value tematic factor strategy fees. Closet NeutralQuality Index had 46-percent strategies sell securities that have appre- indexers and active managers that hug turnover in 2017 similar to turnover of ciated to the point that they no longer factors are at risk of being replaced by a the MSCI USA Diversified Multiple- represent good value, and small-cap more cost-effective factor tilt approach. Factor Index. strategies sell positions that have suc- cessfully outgrown the small-cap Many design decisions go into building The choice of rebalance frequency universe. In both cases, these strategies a successful factor tilt portfolio. Portfolio hinges on the tradeoff between the require selling appreciated positions and construction matters. A well-thought- benefit of incorporating more current realizing gains. Momentum strategies out investment process manifests itself information and the transaction cost may be tax efficient in holding on to in defining factors, translating factors to associated with rebalancing. For exam- winners that are running, but they also weights, choosing rebalance frequency, ple, companies usually release updated tend to have short horizons that may and managing risk, transaction costs, fundamental data on a quarterly basis, result in short-term gain realization. and taxes. Finally, factors have perfor- but prices change daily and valuation Systematic tax-loss harvesting offers the mance cycles, and as a result, integrating ratios change accordingly; also as com- potential to realize losses that may be factors in a holistic manner could achieve panies follow different fiscal calendar used to offset the gains associated with smoother performance and a better years, there are new updates every factor tilts. long-term risk and return trade-off. month. As a result, there could be a benefit from rebalancing a fundamentally Given the differences among factors in Daphne Y. Du, PhD, CFA®, is senior vice driven factor monthly. Price momentum turnover, gain realization, and perfor- president, portfolio manager at Managed Portfolio Advisors and Active Index Advisors, is a different story, because price trends mance cycles, tax management should divisions of Natixis Investment Managers. change all the time and more frequent be an integral part of strategy design as She earned a BA in economics from Nankai rebalancing, such as daily or weekly, shown in equation 1—and not an after- University, an MS in economics from Beijing may be beneficial. Ultimately, portfolio thought. Portfolio managers should University, and a PhD in finance from the managers should balance risk, return, proactively seek opportunities to harvest University of Hawaii at Manoa. Contact her at [email protected]. transaction cost, and taxes in totality losses. For example, when selecting the when designing investment strategies. substitute security after selling a security Dan Price, CFA®, FRM®, is chief investment at a loss, portfolio managers could select officer, overlay strategies at Managed Portfolio Advisors and Active Index Advisors, divisions TAX MANAGEMENT a security with a close match in factor of Natixis Investment Managers. He earned As Benjamin Franklin said in 1789, exposure and an optimal tax lot to defer a BA in biology from Middlebury College. “In this world nothing can be said to gain realization, particularly short-term Contact him at [email protected]. be certain, except death and taxes.” gains. Some gain realization is necessary A major reason that backtested perfor- to capture factor premiums, but striking REFERENCES mance and fund factsheet results may an appropriate balance between the Asness, C., T. Moskowitz, and L. H. Pedersen. 2013. 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WHY FACTOR TILTS MAKE SENSE Continued from page 16

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