Equity factors
The return of single equities can be explained by more than a single risk/return factor (market). Some factors like sector and country seem quite clearly uncompensated. Others like size (small cap vs large cap) and value (vs growth) might have some compensation or not. Some seem to have clear returns.
Factors seem to be better compensated in smaller stocks and in less liquid markets (developed ex-US, emerging).
Similar factors may exist in bonds.
Factors can be implemented as pure via a long-short portfolio, together with market exposure as long only or combined into multi-factor portfolios. However, the factors are somewhat overlapping and correlated to each-other and to the market as a whole.
I present these factors in order of how much I helieve them.
Momentum
| Real return | 3.5-4.5% |
| Volatility | 8% |
| Correlation | 0.3 |
| Testfolio | MTUM / IMTM |
| Inflation | Nominal |
Cross-sectional momentum has no rational explanation, but is undeniable and a strong performer. One concern is that it can “crash”, often during volatile markets.
Quality
| Real return | 2-6% |
| Volatility | 7% |
| Correlation | 0 |
| Testfolio | QUAL / IQLT |
| Inflation | Nominal |
Quality is a broad term that can encompass many desirable metrics: profitability, investment, stability, low internal leverage. As such these are often priced higher than comparable companies with lower quaility, but probably not enough.
Low volatility
| Real return | 1% |
| Volatility | 6% |
| Correlation | 0 |
| Testfolio | USMV |
| Inflation | Nominal |
Low volatility is a weird factor in that it is more of a modification of the market factor. It states that taking on more market risk in a stock is compensated less than expected. This could be because of leverage aversion or lottery preferences. However, the evidence and returns of this have been weak. And leverage aversion may be rational.
Value
| Real return | 0% |
| Volatility | 4% |
| Correlation | 0 |
| Testfolio | VTV |
| Inflation | Nominal |
Value is defined as having a low ration of price to some fundamental measure of value, such as earnings, book value or free cash flow. This is a classic factor that has underperformed for the last 20 years. Perhaps it has gotten so popular that it is now overcrowded, or it was never there, or it will recover.
Size
| Real return | 0% |
| Volatility | 8% |
| Correlation | 0 |
| Testfolio | DFSTX |
| Inflation | Nominal |
Another classic factor, this states that equities with a smaller market capitalization should perform better than larger market capitalization equities. There is no rational reason why this should be the case, and it hasn’t worked for the last 20 years. Especially after adjusting for the fact that small cap tends to be higher beta.