Overweight subsection 1

While it is all but impossible to predict what company will be the next Google, or if energy companies will outperform consumer goods producers next year, or what stocks will do after the next election, when we look at the market as a whole and observe how all assets vary according to certain measures, economists have found that there are certain factors that, on average, predict that an asset will outperform if it scores highly on that factor, compared to an asset that scores low on the same factor.

Rather than looking for “stories” that appeal to our narrative sense as investors about what a company is doing or what innovations and events will unfold, these factors are found by doing statistical analysis on an asset’s underlying economic fundamentals (such as the financial statements for a company stock), or the time series of the asset’s price, or some combination of the two. There are four factors we focus on, which have been observed over long time periods across global markets in multiple asset classes: they are value, momentum, carry, and quality.

Value

Value

The value premium, and “value investing” in general, is the most familiar of these factors to most investors. The idea of value investing goes back to at least the Great Depression, when Benjamin Graham released his classic “The Intelligent Investor.” Warren Buffet, his student, is the world’s most famous value investor. The idea behind value investing is simple: “cheap” assets are a better deal than “expensive” assets and should outperform them in the long run. What’s a cheap asset? Say company A and company B both have stocks that sell for $20 a share. But company A earns $5 per share in profits and company B only earns $2 per share. Company A is a value stock: you can buy a share of its earnings for cheaper than company B.

Stocks that score high on the value factor have historically outperformed low-value-factor stocks in virtually every market studied by an impressive margin. The concept can also be extended to bond markets by comparing yields relative to credit-quality, currency markets by price relative to purchasing power parity, and commodities by price relative to producer price index.

Momentum

Over relatively short time periods – three to twelve months – the performance of an asset tends to persist; recent outperformers continue to outperform and recent underperformers continue to underperform. Knowledgeable investors are often skeptical of this claim: we’re often told that chasing returns will lead to bad performance. The length of the time horizon is key: most “return-chasing” investors jump into new investments after they’ve had a good run for a couple years or more. Over such long time frames performance is more likely to revert to the mean. It seems that capital markets often adjust slowly to new information (perhaps because so much money is controlled by investment committees of large, bureaucratic organizations) and so it often takes several months for asset prices to adjust; this gives more nimble investors the opportunity to profit off the momentum factor observed in stock, bond, currency, and commodity markets.

Carry

Carry is the profit earned from holding an asset, assuming no change in prices. While the interest or dividend earned by holding a stock or bond might meet this definition, carry typically refers to bets on the stability of two different prices. Currency carry is the most commonly known: if an investor can borrow euros at 1% and lend in Australian dollars at 5%, her carry profit is 4% (assuming exchange rates don’t change). Carry also includes taking advantage of different prices on similar assets with different maturities: usually short-term bonds have low yields (high relative price) and long-term bonds have higher yields (low relative price). If an investor buys a long-term bond and holds it until it becomes a short-term bond and is now selling at a higher price, he earns a carry profit as the bond appreciates. Carry trades have been shown to be profitable across a variety of fixed income and derivative markets.

Quality

Across the broad categories of assets in the market, like stocks vs. bonds vs. cash, more risk means greater long-run return. But within specific classes of assets like large US stocks or non-investment grade debt, this relationship breaks down. It turns that within specific asset classes, high quality, low-risk securities have about the same average returns as low-quality, high-risk securities, but with much less risk. The simplest, most universal measure of quality is the volatility of an asset’s price changes over a certain time, where lower volatility is better. Asset specific measures like profitability within equities and credit rating within fixed income can add robustness. Emphasizing quality has historically improved risk-adjusted performance significantly, especially when combined with the other factors above.

Overweight subsection 3 chart

Certain investment strategies have outperformed over the long run. Stocks that score high on value or momentum, for example, have outperformed stocks the score low on these factors by over 6% per year on average in the US, going back to the 1920s. (Source: Ken French’s Data Library)

Overweight subsection 4

We use investments that seek to capture the premiums associated with these factors in a systematic, diversified manner that still keeps costs low and shouldn’t significantly increase risk. Some of our chosen funds have decades-long track records of beating their benchmarks, and are advised by Nobel-prize winning economists. Historically, emphasizing value, momentum, carry, and quality factors in a diversified, moderate risk portfolio has earned average annual premiums of 1.4% or more.*

*Source: Asness et al. (2015) pp. 51 Based on a 10% allocation to the authors’ model portfolio. This conservatively approximates our exposure to these investment styles.

References

Value, momentum, carry, and quality investment styles have significantly outperformed benchmarks in stock, bond, commodity, and currency asset classes: “Investing with Style” by Asness, et al. (2015)