Koenig: Factors Versus Styles

The style box is dead. Vive le style box!

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Reviewed by: David Koenig
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Edited by: David Koenig

The style box is dead. Vive le style box!

The early 1980s was a time of tremendous innovation as technological advances spurred new products and thinking across industries from computing to music to autos to investing. 1981 brought us innovations such as IBM's first PC, the MTV video music network, the DeLorean sports car and the first institutional index fund.

A few years later, Russell Investments introduced the Russell 2000 Index, the first small-cap benchmark, followed by the first growth and value style indexes. Together, these indexes formed the basis for the now-well-known style box, and have helped shaped the way investors construct portfolios for many years.

Since that time, indexing has grown dramatically and is now seeing another era of innovation, with the introduction of a wide variety of factor indexes focused on individual factors such as low volatility, quality, momentum and value.

Factor investing has quickly graduated from playing open-mic night at small nightclubs to headlining the largest arenas. And investors are working to understand these strategies—how factors are similar to or different from traditional styles and how these strategies can be incorporated into their portfolios.

Some industry practitioners have asserted that factor investing might replace traditional styles and the style box. Others have dismissed factor investing altogether as a series of one-hit wonders, potentially positioning investors for disappointment down the road.

So, what's the right answer? Will factor investing prove to be as influential and lasting as indexing itself, or as short-lived as the DeLorean? As with any new concept, the answer is more nuanced than a simple thumbs-up or thumbs-down.

Factor indexes represent new tools that investors can use to construct more precise portfolios based on their unique objectives and tolerance for risk. For many, a combination of traditional styles and new factor strategies may provide the best solution for their investment needs.

Distinguishing Factors From Styles

FactorsStyles
Market Coverage
  • Focused exposure to stocks with high capture of one targeted factor
  • One-sided subset of a market segment, e.g., High Momentum but no Low Momentum
  • Broad exposure to sets of characteristics
  • Splits market segments into symmetrical, two-sided components, e.g., Growth and Value
Factor Capture
  • High factor capture
  • Significant bet on targeted factor
  • Moderate factor capture
  • Moderate tilt toward factor characteristics
Weighting
  • Factor-weighted
  • Market capitalization-weighted
Rebalance/Turnover
  • Semiannual, quarterly or monthly rebalance
  • Higher turnover
  • Annual reconstitution
  • Low turnover
Active vs. Passive
  • High active share
  • Focused subset of parent index
  • Lower active share
  • Broader subset of parent index

 

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What Are Factors?

Factors are the underlying drivers of risk and return within a portfolio of securities. Every portfolio has exposure to multiple factors at varying levels. For stock portfolios, these include common systematic factors such as value, growth, size, momentum, volatility, industry and others.

The behavior of a portfolio can be explained in terms of its exposure to these factors plus the idiosyncratic—or stock-specific—behavior of the securities in the portfolio. The portfolio's exposure to systematic factors can be quantified by decomposing them through the lens of a multifactor risk model such as those constructed by Axioma or Barra, two leading providers of risk analytics platforms.

Although factor indexes are a relatively recent innovation in the investment industry, it's important to understand that factor investing has been on the scene nearly as long as the Rolling Stones. A wide body of academic and practitioner research has studied various factors and found that individual factors such as value, low volatility, momentum and a few others have positive payoffs over time, while other factors such as high volatility have negative payoffs.

Similar to styles, individual factors can move in and out of favor and experience extended periods of both outperformance and underperformance relative to their parent index.

In recent years, index providers such as Russell, MSCI and others have developed factor indexes based on those factors that tend to have positive payoffs over time. These indexes are designed to capture high levels of exposure to the targeted factor, and in some cases are optimized to also minimize exposure to all of the other nontargeted factors.

Products from ETF providers such as iShares and State Street that are designed to track these indexes have given investors a whole new set of tools for constructing precise portfolios tailored to deliver desired factor exposures.

What Makes An Index A Factor Index?

Some have questioned whether factor indexes truly provide anything new, since indexes focused on small-cap, value, etc., have existed since the 1980s. It's important to recognize, however, that every index has factor exposures at some level. For example, the S&P 500 Index has biases toward factors such as mega cap, growth and momentum.

But just because an index has factor exposures does not make it a factor index. Factor indexes are specifically designed with the objective of providing a more focused exposure to a specific factor—essentially a bigger bet on that factor's performance.

Although they are often well-diversified, factor indexes typically consist of a subset of securities from a parent index. This means factor indexes generally have higher active share, or differences in holdings relative to their parent index, than do traditional style indexes.

For example, the Russell 1000 Low Volatility Index holds up to 200 securities, compared with 1,000 securities for the parent index and approximately 660 securities for styles indexes such as the Russell 1000 Value and Growth Indexes.

Another difference is that factor indexes typically weight securities by exposure to the targeted factor rather than by market capitalization. And because consistent factor exposure is a goal of factor indexes, they tend to rebalance more frequently and have higher turnover than market-cap-weighted indexes. (More information on construction of factor indexes can be found here.)

 

What Are Styles?

By contrast, traditional style indexes are designed to represent broader market segments based on investment styles and sets of characteristics that are focused on by professional investment managers, making them excellent benchmarks for evaluating the skill of active managers.

These include styles such as growth and value, defensive and dynamic, large-cap and small-cap. The astute reader will undoubtedly notice that each of these styles is two-sided—growth is complemented by value, defensive is complemented by dynamic, etc.

Style indexes traditionally were designed to be symmetrical and to split a complete market segment into complementary components that sum to the whole segment. For example, the Russell 1000 Growth Index plus the Russell 1000 Value Index combine to make the Russell 1000 Index.

The symmetrical nature of styles is a key distinction relative to investor-oriented factor indexes, which tend to be one-sided and typically focus only on the direction with the positive payoff. This symmetrical nature provides an intuitive measure for understanding relative exposure. In other words, we know that equal dollars invested on each side of the style framework is style-neutral. The same is not necessarily true for factors. Style indexes are also typically market-cap-weighted, representing a truly passive exposure, and tend to have lower turnover than factor indexes because they don't require regular rebalancing.

Using Factors And Styles

So, with an ever-growing set list of indexes, how should investors select from among traditional style index strategies and newer factor indexes in building their portfolios?

Today, most investors include allocations to both growth and value and to large-cap and small-cap investments within the strategic core equity portion of their portfolios. These traditional style indexes may continue to form the basis for the core of many investors' portfolios because of their broad, comprehensive exposures.

Using both styles also allows investors to dynamically adjust their portfolio's exposures toward or away from either style. The Beatles and the Stones, rather than the Beatles or the Stones. In this case, factor indexes can be used to more precisely tailor core allocations to include, for example, a low-volatility index or a satellite allocation to momentum to benefit from its lower correlation with other factors such as value.

For some sophisticated investors, constructing a portfolio purely from a collection of factor indexes is also possible. This approach allows for very precise allocations to desired factor exposures as well as dynamic adjustments to specific factors over time. Investors taking this approach would be well-advised to work closely with an investment professional, as it is no simple task to either properly construct a factor portfolio or to accurately time factor exposures over market cycles.

For most investors, some combination of traditional styles and new factor index strategies may be the best of both worlds. This approach allows investors to construct portfolios with broad, diversified and familiar exposures while also offering the opportunity to use factor indexes to precisely tailor the portfolio's exposures toward or away from desired or undesired risks.

 

Harmonizing With Styles And Factors

When MTV launched in 1981, the first video played on the new video music network was "Video Killed the Radio Star" by a relatively obscure band named the Buggles. While MTV might have launched a new era of music video, it did not end up killing radio as the song predicted.

Radio remains highly relevant in the age of video, leading to new station formats and has even evolved into new digital applications such as Pandora and Spotify as technology has continued to advance.

Similarly, the introduction of indexing did not replace active management; rather, the two continue to coexist. Both traditional styles and new factor indexes will likely remain relevant for investor portfolios for many years.

Factor indexes are far from one-hit wonders, but neither will they replace traditional style indexes or the style box. We might want exposure to the new melodies, but that doesn't mean we will ever just discard the time-tested classic tunes by the Beatles or the Stones.

Factor strategies represent an enhancement and new set of tools that investors can use alongside their traditional, familiar style exposures to construct portfolios that deliver their desired exposures based on their unique objectives and risk tolerances.


David A. Koenig, CFA, FRM, is an investment strategist with Russell Investments.

Please note: Indexes are unmanaged and cannot be invested in directly. Returns represent past performance, are not a guarantee of future performance, and are not indicative of any specific investment. Russell's publication of the Indexes or Index constituents in no way suggests or implies a representation or opinion by Russell as to the attractiveness of investing in a particular security. Inclusion of a security in an Index is not a promotion, sponsorship or endorsement of a security by Russell and Russell makes no representation, warranty or guarantee with respect to the performance of any security included in a Russell Index.

Opinions expressed by Mr. Koenig reflect market performance as of May 19, 2014 and are subject to change at any time based on market or other conditions without notice. Past performance does not guarantee future performance.

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