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Factors are one of the building blocks of a systematic approach. They define the characteristics of attractive and unattractive stocks and provide a consistent, rules-based implementation of an investment philosophy. How does it work? In a long-only portfolio, a systematic factor strategy will overweight stocks that rank highly on a certain factor and underweight stocks that rank poorly on that factor. Using factors allows us to explain exactly why the portfolio is positioned the way it is and what the drivers of return are—every time.
Value investing is one of the best-known and most-studied approaches to outperforming the broader market over the long term. Equity valuations can be quantified by the ratio of a fundamental anchor—like book value, earnings or cash flows—over price. There are many ways to measure the valuation of a stock—we find that using a combination of measures yields the most robust results.
Sources: AQR and Kenneth R. French Data Library. Portfolios from Kenneth R. French Data Library formed based on book-to-market; quintiles are equal-weighted; returns are excess of cash. Returns sourced from “Portfolios Formed on Book-to-Market.” See Kenneth R. French Data Library for further details. These are not the returns of an actual portfolio AQR manages and are for illustrative purposes only. Past performance is not a guarantee of future performance.
Simply put, momentum is the idea that assets that have recently outperformed will tend to do better than assets that have recently underperformed. This tendency has been documented in at least as many asset classes as value and over even longer histories. A simple yet common measure of momentum is the last 12-months price return of an asset. Importantly, the returns of the momentum premium have tended to be negatively correlated to those of the value premium—which means they may offer investors great diversification benefits.
Source: AQR and Kenneth R. French Data Library. Portfolios from Kenneth R. French Data Library formed based on 12-month momentum, skipping most recent month; quintiles are equal-weighted; returns are excess of cash. Returns sourced from “10 Portfolios Formed on Momentum.” See Kenneth R. French Data Library for further details. These are not the returns of an actual portfolio AQR manages and are for illustrative purposes only. Past performance is not a guarantee of future performance.
Defensive stocks tend to be low-risk, stable or safe. As with most factors, there is more than one way to characterize a defensive company—from purely fundamental measures such as profitability and general quality to statistical measures such as low beta and low volatility. We find that both may help identify attractive stocks. For example, a defensive portfolio is likely to go long or overweight stocks that rank high on earnings quality and profitability and rank low on beta and volatility.
Source: AQR and CRSP/Compustat data. Portfolios formed based on gross profits-to-assets using all stocks in the CRSP universe; quintiles are equal-weighted; returns are excess of cash. These are not the returns of an actual portfolio AQR manages and are for illustrative purposes only. Past performance is not a guarantee of future performance.
Combining Factors into a Multi-Factor Portfolio
The combination of multiple factors has been shown to be more effective than any one individually. But how you combine them matters.
For example, how would you build a portfolio that seeks to capture both value and momentum premia? The easiest approach would be to separately buy the stocks that look most attractive from a value perspective and also buy the stocks that look most attractive from a momentum perspective. This is essentially constructing an aggregate portfolio by mixing stand-alone-style portfolios.
We believe there’s a better way. Theoretically and empirically, we find that buying stocks that look attractive from both value and momentum perspectives is more effective than considering each factor separately. In other words, applying investment themes in an integrated manner may be better than mixing individual styles in an “a la carte” manner.
Factor Diversification Versus Timing
Factors may offer long-term sources of returns, but that doesn’t mean they make money at the time. Can investors do better—can factors be successfully timed?
Factors (like many other sources of return) can become cheap or expensive compared to their histories. It might seem intuitive to test the efficacy of factor timing by overweighting a factor when it’s cheap and underweighting when it’s expensive.
Theoretically and empirically, we find it’s not so easy. Factor timing, especially contrarian factor timing, is far from an efficient way to make returns. Why? First, there is only a weak predictive relationship between how cheap a factor might seem and its future returns. Second, we find the returns from contrarian factor timing are meaningfully correlated to the returns from the value factor itself. What that means for factor investors is there’s only limited benefit (if any at all) for portfolios that already have a value tilt or an allocation to the value factor.
Instead, we find that strategically diversifying across multiple factors to be more effective, not just in U.S. stocks, but in other geographies and asset classes too. Diversification across multiple factors doesn’t rule out timing entirely, but it raises the bar more than most investors might realize.
Factor timing is likely even harder than market timing.
This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and AQR Capital Management, LLC (“AQR”) to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. This document is intended exclusively for the use of the person to whom it has been delivered by AQR, and it is not to be reproduced or redistributed to any other person. The information set forth herein has been provided to you as secondary information and should not be the primary source for any investment or allocation decision. Past performance is not a guarantee of future performance.
This material is not research and should not be treated as research. This paper does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AQR. The views expressed reflect the current views as of the date hereof and neither the author nor AQR undertakes to advise you of any changes in the views expressed herein.
The information contained herein is only as current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. The information in this presentation has been developed internally and/or obtained from sources believed to be reliable; however, neither AQR nor the author guarantees the accuracy, adequacy or completeness of such information. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially, and should not be relied upon as such.
The information in this paper may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein, and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.
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