Fundamentals are, after all, “factors,” or better yet, metrics that help determine the intrinsic value of a company. Equity risk factors—those we commonly refer to in factor investing—are the drivers of equity returns, and something most people know well.
But the two are not the same. As the ETF market—particularly the smart-beta segment—gathers steam and attracts new investors into the fold, we thought we’d talk about these two popular investing approaches.
Smart-beta equity ETFs forgo market-capitalization weighting in the pursuit of better risk-adjusted returns over time. By definition, these funds don’t rank stocks in a portfolio based on their market cap—the way the S&P 500 is ranked.
Widely Accepted Factors
Some of these strategies seek outsized returns relative to the broad market by focusing on specific factors. There are five or six widely accepted equity risk factors, based on academic research, over the years.
To MSCI, the factors of note include value, size, momentum, high dividend, quality and volatility. At any given time, any of these factors may be driving a stock’s performance, and outperforming the broad market as measured by a market-cap-weighted index.
“A factor can be thought of as any characteristic relating to a group of securities that is important in explaining their return and risk. A large body of academic research highlights that long-term equity portfolio performance can be explained by factors,” MSCI said in a research paper.
Harvesting Risk Premia
“Certain factors have historically earned a long-term risk premium and represent exposure to systematic sources of risk,” MSCI added. “Factor investing is the investment process that aims to harvest these risk premia through exposure to factors.”
FTSE Russell lists five factors: value, volatility, size, momentum and quality as the equity factors that deliver different return patterns.
Consider for example, the one-year performance of three U.S.-large cap ETFs—one broad, two single-factor, side by side: the Vanguard S&P 500 (VOO | A-98), the Vanguard Value (VTV | A-100) and the Vanguard High Dividend Yield (VYM | A-95). Different factors mean different results:
Chart courtesy of StockCharts.com
The thing about factor investing is that different factors should outperform the market at different times, and go through periods of underperformance. Addressing that, and the issue of factor diversification, is what’s driving a roster of multifactor ETF launches coming to market in recent years.
The State Street lineup of Quality Mix funds is a pioneer of sorts in this segment, with the first flavors of multifactor strategies popping up in 2014. For example, the SPDR MSCI Emerging Markets Quality Mix ETF (QEMM | D-89) tracks an index of emerging market securities equally weighted between three subindexes: value, minimum volatility and quality—three factors in one wrapper.
What Is Fundamental Indexing?
As Russell put it in a recent research paper, picking factors amounts to an intentional exposure to risk premium. Fundamental indexing, on the other hand, is a “strategy-based” decision—it has more to do with the weighting methodology of a portfolio, the ranking of securities.
“Strategy-based exposures are factor exposures in disguise,” Russell said, noting the similar performance over time of a value-based strategy and a fundamental-index based strategy.
But that’s because fundamental indexing strives to get to the intrinsic value of a company. It does so by looking at accountinglike factors, also known as fundamentals. A great example of this approach in the world of ETFs is the work of Research Affiliates on the RAFI family over the years. The company has a vast lineup of fundamental indexes that are widely used across the industry.
Market Cap Falls Prey To Inefficiencies
The idea behind fundamental investing is that markets are inefficient, and equity investing that relies on market-cap-weighted indexes would consistently fall victim to these inefficiencies by “overweighting overpriced stocks and underweighting undervalued stocks,” according to RAFI.
The RAFI methodology weights not by market capitalization, but by specific characteristics—or fundamentals—of a company such as gross revenue, equity book value, gross sales, gross dividends, cash flow and total employment.
RAFI calls these “main street” measures of a company size, rather than the commonly used metric of market capitalization.
So, factor investing and fundamental investing aren’t the same thing, but they are both looking to find the stocks that are bound to deliver outsized gains relative to the cap-weighted broad market.
Contact Cinthia Murphy at [email protected].