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Factor Investing | An Introductory Guide

Factor investing involves asking investors to select the most important qualities in stocks they purchase and organize the holdings in their portfolios…

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This article was originally published by Stock Investor

Factor investing involves asking investors to select the most important qualities in stocks they purchase and organize the holdings in their portfolios accordingly.

If you tend to gravitate towards growth rather than value stocks, high-momentum versus low-momentum equities, or large-cap over small-cap companies, you are a factor investor. Factor investing is just the selection and prioritization of equities based on one or more chosen qualities — also known as “factors” — and use them to create an optimal portfolio with minimal risk and maximal returns.

This style of investing is on the rise in recent years as more successful funds allocate their capital according to factor-based models. The factors prioritized can range from value to momentum to size or many other underlying qualities. Factor investing is then less of a specific strategy and more of an overarching philosophy of investing. It simply argues that risk and returns can be optimized by choosing securities based on a few key attributes tied to good performance.

Factor Investing Aims to Manage Risk and Diversify Assets Without Sacrificing Returns

Going “all in” on any particular equity is rarely a good idea — while it is possible to make great returns with a few lucky investments, the risk associated with this strategy is astronomical. Smart investors instead can opt to minimize risk by choosing to diversify their portfolio. This is done by allocating their money to multiple equities, markets, asset classes and other distinguishing factors so that any unforeseen loss is far less decimating.

However, if the supposedly diverse assets move in lockstep with the greater market, virtually all of the gains of diversification are lost. This is a common mistake made by new investors — they mean well by attempting to diversify their portfolio, but often distribute their capital among stocks and bonds that rise and fall in tandem.

As an example, some young investors will concentrate nearly all of their money in the five most popular technology stocks: Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX) and Alphabet (NASDAQ:GOOG), also known as the FAANG stocks. Since all five of these companies respond to stock market conditions in the same way, however, splitting capital among them does very little to minimize risk and reap the benefits of diversification.

Factor investing offers a solution: by selecting companies based on distinguishing factors that are reliable predictors of returns, investors can diversify in a more meaningful way without sacrificing profitability. Knowing which factors to concentrate your portfolio on can then inform smarter diversification decisions, both within and across asset classes.

Factor Investing is Driven by Two Main Types of Factors

There are two primary categories acknowledged by factor investors: macroeconomic factors and style factors.

Macroeconomic factors address broad risks across multiple asset classes. They can include economic growth as a result of exposure to the business cycle, interest-rate movement, unemployment and inflation or exposure to changes in prices. Other common macroeconomic factors are credit risk, liquidity and political risks of emerging markets.

But risk from the greater market cannot fully encompass how safe or bold a given investment is. That’s why we also use style factors, which capture risk and returns within asset classes. Popular style factors are value (how much a stock is discounted relative to its fundamentals), volatility, momentum and size. Investors and funds evaluating style factors also frequently look at financial health and income incentives to hold riskier securities.

These style factors are often acknowledged in smart beta investing strategies. This kind of factor investing focuses on the mathematical data used to predict value, volatility, size, quality, momentum, beta and other equity-specific metrics. It then attempts to use this data to redistribute capital in a more optimal way than typical index funds.

Factor investing as a whole, however, will typically use a mix of style factors and macroeconomic factors in search of an optimally diversified portfolio. Some funds will focus only on smart beta and style factors while others will put more emphasis on greater market conditions. How much weight is given to each individual factor will differ from one investor to the next.

Some Factors Allow Investors and Fund Managers to Beat the Market

Investors interested in factor investing are looking for the specific factors that, when tracked effectively, allow them to consistently outperform the S&P 500.

For example: there is some evidence that low-volatility stocks tend to outperform the market in the long-term. Investing in primarily low-volatility stocks, however, eliminates the potential gains brought on by big, market-moving, risky stocks.

A more common factor for mutual funds and exchange-traded funds (ETFs) to focus on is momentum. Momentum-based funds select stocks to diversify their portfolios by using recent performance, and, when well-managed, tend to perform very well. Shown below are three of the most popular momentum-based factor investing funds charted with the S&P 500 as a baseline (the horizontal red line).

Chart provided by StockRover, start your free trial here.

We can see that these kinds of funds are frequently above the baseline, meaning they outperform the market and have a positive alpha.

The Most Famous Example of Factor Investing is the Fama-French 3-Factor Model

Before we can understand multi-factor models, we need to introduce the capital asset pricing model — CAPM, for short — a formula for calculating the expected returns of an asset given its risk. CAPM takes into account the risk-free rate, beta and a market risk premium to estimate the return on investment for any given equity.

Multi-factor models often expand on this. Developed by Fama and French in 1992, the Fama-French 3-Factor Model is an extension of CAPM that accounts for a few additional variables: book-to-market value, excess returns and size. Fama and French built an econometric regression from historical stock prices to find that small-cap stocks and value stocks tend to outperform larger growth stocks in the long term — they were awarded a Nobel Prize for their research later in the 1990s.

Taking these factors into account means prioritizing small-cap, value stocks in diversification and stock selection. Investors using the Fama-French 3-Factor Model, if the mathematical data carries into application, can expect increased returns over a 15 year horizon.

Most funds using a factor investing strategy operate in a similar way: they select a few macroeconomic or style factors that they believe will increase returns, and adjust their portfolio accordingly. The original model developed by Fama and French only considered three primary factors, but a modern update of the same model now uses five. The Fama-French 5-Factor Model uses the original three factors (book-to-market value, excess returns and size) as well as predicted future earnings and internal investment. Other variations on the system may include momentum, quality, low volatility or other similar factors to boot.

Many ETFs Employ Factor Investing Strategies

Applying factor investing strategies in your own portfolio can be powerful but time-consuming. Many exchange-traded funds, however, already employ these principles. Listed below are some of the best ETFs focused on factor investing:

Ticker Market Cap Latest Close Price
BBUS $0 $83.17
GSLC $0 $91.34
USMC $6.32M $42.12
QUS $0 $126.08
DEUS $0 $46.52
PQLC $0 $74.65
VFMF $0 $103.06
EUSA $501.94M $88.06
EQL $229.76M $104.44
RSP $12.38B $156.88
FNDX $7.45B $56.04
PRF $7.71B $164.48
RWL $433.33M $76.01
JMOM $0 $46.65
MTUM $15.76B $183.10
FDMO $0 $51.75
QUAL $22.86B $141.39
SPHQ $2.30B $50.81
QSY $77.83M $62.26
LGLV $0 $142.31
SIZE $667.89M $134.93

Factor Investing Lets Investors Organize a Portfolio According to What They Care About Most

While some portfolios inspired by factor investing strategies will be riddled with complex statistical models, others are a conglomerate of stocks and equities chosen because they share some common quality. Factor investing, as a whole, has risen more and more in popularity as the technology to track factors becomes accessible both to fund managers and the general public.

Regardless of their complexity, factor investing strategies help savvy investors diversify and organize their portfolios to maximize profit with minimal risk taken. For additional information on factor investing and similar strategies, read our articles on momentum investing and smart beta investing.


jonathan

Jonathan Wolfgram is an editorial staffer who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes for www.DividendInvestor.com and www.StockInvestor.com.


The post Factor Investing | An Introductory Guide appeared first on Stock Investor.

Economics

Goldman Raises Year-End Oil Price Target To $90

Goldman Raises Year-End Oil Price Target To $90

Just days after Goldman’s head commodity analyst Jeff Currie told Bloomberg TV that the bank…

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Goldman Raises Year-End Oil Price Target To $90

Just days after Goldman's head commodity analyst Jeff Currie told Bloomberg TV that the bank anticipates oil spiking to $90 if the winter is colder than usual, on Sunday afternoon Goldman went ahead and made that its base case and in a note from energy strategist Damien Courvalin, he writes that with Brent prices reaching new highs since October 2018, the bank now forecasts that this rally will continue, "with our year-end Brent forecast of $90/bbl vs. $80/bbl previously."

What tipped the scales is that while Goldman has long held a bullish oil view, "the current global oil supply-demand deficit is larger than we expected, with the recovery in global demand from the Delta impact even faster than our above consensus forecast and with global supply remaining short of our below consensus forecasts."

Among the supply factors cited by Goldman is hurricane Ida - the "most bullish hurricane in US history" - which more than offset the ramp-up in OPEC+ production since July with non-OPEC+ non-shale production continuing to disappoint.

Meanwhile, as noted above, on the demand side Goldman cited low hospitalization rates which are leading more countries to re-open, including to international travel in particularly COVID-averse countries in Asia.

Finally, from a seasonal standpoint, Courvalin sees winter demand risks as "further now squarely skewed to the upside" as the global gas shortage will increase oil fired power generation.

From a fundamental standpoint, the current c.4.5 mb/d observable inventory draws are the largest on record, including for global SPRs and oil on water, and follow the longest deficit on record, started in June 2020.

For the oil bears, Goldman does not see this deficit as reversing in coming months as its scale will overwhelm both the willingness and ability for OPEC+ to ramp up, with the shale supply response just starting.

This sets the stage for inventories to fall to their lowest level since 2013 by year-end (after adjusting for pipeline fill), supporting further backwardation in the oil forward curve where positioning remains low.

But what about a production response? While Goldman does expect short-cycle production to respond by 2022 at the bank's higher price forecast, from core-OPEC, Russia and shale, this according to Goldman, will only lay bare the structural nature of the oil market repricing. To be sure, there will likely be a time to be tactically bearish in 2022, especially if a US-Iran deal is eventually reached. The bank's base-case assumption is for such an agreement to be reached in April, leading the bank to then trim its price target to an $80/bbl price forecast in 2Q22-4Q22 (vs. its 4Q21-1Q22 $85/bbl quarterly average forecast). This would, however, remain a tactical call and a likely timespread trade according to Courvalin, with long-dated oil prices poised to reset higher from current levels, especially as the hedging momentum shifts from US producer selling to airline buying (a move which Goldman says to position for with a long Dec-22 Brent and short Dec-22 Brent put trade recommendations).

 

Meanwhile, the lack of long-cycle capex response - here you can thank the green crazy sweeping the world - the quickly diminishing OPEC spare capacity (Goldman expects normalization by early 2022), the inability for shale producers to sustain production growth (given their low reinvestment rate targets) and oil service and carbon cost inflation will all instead point to the need for sustainably higher long-dated oil prices. Remarkably, Goldman now expects the market to return to a structural deficit by 2H23, which leads it to raise its 2023 oil price forecast from $65/bbl to $85/bbl, and the mid-cycle valuation oil price used by Goldman's equity analysts to $70/bbl.

Translation: expect a slew of price hikes on energy stocks in the coming days from Goldman.

Finally, where could Goldman's forecast - which would infuriate the white house as gasoline prices are about to explode higher - be wrong? For what it's worth, the bank sees the greatest risk on the timeline of its bullish view. On the demand side, it would take a potentially new variant that renders vaccine ineffective. Beyond that, however, the bank expects limited downside risk from China, with its economists not expecting a hard landing and with our demand growth forecast driven by DMs and other EMs instead. This leaves near-term risks having to come from the supply side, most notably OPEC+, which next meets on October 4. And while an aggressively faster ramp-up in production by year-end would soften (but not derail) our projected deficit, it would only further delay the shale rebound, which would reinforce the structural nature of the next rally given binding under-investment in oil services by 2023. In addition, a large ramp-up in OPEC+ production would simply fast-forward the decline in global spare capacity to historically low levels, replacing a cyclical tight market with a structural one.

The full report as usual available to pro subscribers in the usual place.

Tyler Durden Sun, 09/26/2021 - 20:36
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Economics

Weekly Market Pulse: Not So Evergrande

US stocks sold off last Monday due to fears over the potential – likely – failure of China Evergrande, a real estate developer that has suddenly discovered…

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US stocks sold off last Monday due to fears over the potential – likely – failure of China Evergrande, a real estate developer that has suddenly discovered the perils of leverage. Well that and the perils of being in an industry not currently favored by Xi Jinping. He has declared that houses are for living in not speculating on and ordered the state controlled banks to lend accordingly. Evergrande is known as a real estate developer and it certainly is but it is also a sprawling company with investments in multiple industries including, of course, an electric car company. Cutting off its financing isn’t just going to affect the Chinese real estate market. And real estate accounts for roughly 70% of household net worth in China so everyone in the country is going to take a hit. But is there a connection to the US or other developed country stock markets?

Real estate represents anywhere from 15 to 25% of the Chinese economy depending on what source you want to believe. The exact number isn’t really important, just suffice it to say that construction is a very large part of China’s economy and speculating on real estate is a national pastime. But the impact of it goes well beyond China. It is well known – according to the news reports I read – that China’s share of global commodity consumption is large and a large part of that goes to the construction industry. I read some research last week that claimed China’s property sector accounted for 20% of global steel and copper output. That sure sounds big and scary – as I’m sure the authors intended – but I would just point out that copper prices are near their all time highs and actually finished higher last week. The general commodity indexes were higher too. If Evergrande’s demise is going to materially impact commodity demand you wouldn’t know it from last week’s action. Maybe China’s commodity consumption isn’t “well known” in the commodity pits.

The doom and gloom crowd spent all of last week trying to convince investors – or themselves – that Evergrande is China’s “Lehman moment”, based on nothing more than the fact that Evergrande and Lehman both involved real estate. And in the case of Lehman that connection was incidental but superficially I guess the comparison made sense. There are certainly banks with exposure to Evergrande but the vast majority of them are Chinese. HSBC has been mentioned as having exposure but they stopped lending on Evergrande properties a few months ago. UBS was said to have exposure but the CEO said last week it was immaterial. Credit Suisse, which seems to be the new Citibank, involved in just about everything that has blown up the last few years, was so happy they avoided this one they almost broke an arm patting themselves on the back. US banks, as best I can tell, have no exposure. There are some junk bond funds with exposure but for the ones I looked at, it was a rounding error. There just doesn’t seem to be much interconnection with the rest of the global financial system and that was reflected in credit default swaps and credit spreads which barely moved on the week. 

Evergrande appears to be mostly a domestic China concern, at least for now. The impact will be seen in Chinese growth figures which were already on the decline. What does that mean for the rest of the world? I don’t know yet but I am old enough to remember the last time the world’s second largest economy popped a real estate bubble. That was Japan in the early 90s and their economy certainly suffered over the next decade but you’d be hard pressed to find a big blowback on the rest of the global economy. Maybe China will be different but I can easily make a case that a Chinese economic slowdown would be beneficial to the rest of the world. Suppose those estimates of commodity consumption are correct and copper and steel prices take a tumble. That probably wouldn’t be pleasant for Chile and Brazil (iron ore) but I’d guess that the rest of the world would welcome cheaper steel and copper. There are plenty of things to worry about right here in the US with political wrangling over the debt ceiling, a possible government shutdown (which I generally take as a positive) and potential tax and spending hikes. I see no need – yet – to start worrying about Xi Jinping’s re-Maoing of the Chinese economy.

For stock investors I think the more important event last week was the rapid rise of the 10 year Treasury yield from Wednesday to Friday. I don’t mean to imply that higher rates mean stocks are going to fall because history says that isn’t the likely outcome. Rising rates are generally associated with rising growth expectations which doesn’t exactly strike fear into stock investor’s hearts. And that is what we saw last week as inflation expectations were unchanged as real rate rose exactly the same as nominal rates. Higher rates will affect which stocks perform well though and we started to see that last week. Higher rates and a steeper yield curve were positive for financials. Energy stocks also had a very good week. In general, I’d expect value stocks to perform better if rates keep rising while growth stocks take a breather.

The move in rates last week came with seemingly no trigger. There was no economic data or other event that should have changed growth expectations. Of course, there really wasn’t any spur for the bond rally of the last 6 months either. But eventually the data caught up with the market and it probably will again. I say probably because markets are not always right, just most of the time. What I think we’re going to see over the next few weeks is the market anticipating the end of the Delta surge and the resumption of the economic re-opening both here and in Europe. Whether it does or not or how long it might last or how far it might go I don’t know. But that investors will try to front run the virus isn’t exactly news. Of course people will try to get ahead of events. 

During the course of an  economic cycle, growth will ebb and flow. We’ve just come through a growth rate slowdown and bond yields now seem to be anticipating a growth rate upturn. I’m not convinced yet and there’s a lot of potential potholes ahead – mostly political – so I’ll continue to classify the environment as slowing growth/strong dollar but that may not last long. One thing I still don’t see is any change in the dollar trend. It is a short term uptrend and I’ve acknowledge that but the long term trend is no trend at all. The dollar index is in the bottom half of the range it’s been in for over 6 years and I don’t know what would change that. The lack of a dollar trend makes our job a bit more difficult and shorter term but we play the hand we’re dealt. 


 

The economic data last week was a little better and better than expected but not significantly so. Housing starts improved as have sales over the last quarter but still well below last year’s peak. Existing home sales are still softening and we’re starting to see some price cuts which is the only thing that is going to have a big impact on sales.

The monthly reading of the CFNAI fell back a bit but the 3 month average moved higher to 0.43, a reading that indicates the economy continues to grow above trend. We had a slowdown but it didn’t amount to much.

 

 

 

This week’s data includes durable goods, personal income and consumption, the Chicago PMI and the ISM manufacturing index. I think the two to keep an eye on are income and consumption. It will be interesting to see if either was impacted by the impending end of extended unemployment benefits.

 

Commodities had a good week which seems curious considering the potential growth impact of Evergrande. But as the title says, maybe it isn’t so Grande. Maybe it is just pequeno. 

US and European stocks were up last week while the rest of the world was down. Is that because a China slowdown is good for the US and Europe and bad for Asia and Emerging markets more generally? Maybe but I think I’ll wait for more evidence on that front before making any big pronouncements.

Value outperformed last week across all market caps.

 

As I said above financials and energy led last week. Of equal importance I think is that real estate and utilities – both rate sensitive – lagged the field. If rates keep rising, that seems likely to continue as well. 

 

The 10 year Treasury yield bottomed in March 2020 around 40 basis points. It rose and then fell back to about 50 basis points in August of last year. It rose too far, too fast (1.75%) and the last six months has been nothing but a correction of that trend. Now, it appears rates are resuming their rise. How far will they go? Assuming the Delta end/re-re-opening narrative takes hold and there are no surprises along the way – some very large assumptions – my inner trader says about 1.85% as a first target. But that’s just an extrapolation so I wouldn’t place any big bets on it. What most investors should know is that rates are in an uptrend because the economy continues to recover from COVID. We had a growth rate slowdown and so far that’s all it was. And the market says it is ending. I’ll take that over all the breathless Evergrande articles any day.

Joe Calhoun

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Economics

As Margins Begin To Slide, Will Corporations Choose To Defend Profits Or Absorb Transitory Shocks

As Margins Begin To Slide, Will Corporations Choose To Defend Profits Or Absorb Transitory Shocks

Having spent much of the summer warning…

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As Margins Begin To Slide, Will Corporations Choose To Defend Profits Or Absorb Transitory Shocks

Having spent much of the summer warning that as a result of surging labor costs, commodity prices and generally "transitory hyperinflation", corporate margins would tumble (which in the view of Morgan Stanley would lead to a 10% correction), three weeks ago we warned that we are about to see a surge in profit warnings as the realization that the current unprecedented ascent in prices is going to be anything but transitory.

Sure enough, shortly after we noted that "Profit Warnings Are Coming Fast And Furious As Q3 Profits Brace For Big Hit" it wasn't until Nike and FedEx's dismal outlooks that the world finally paid attention to the coming stagflationary wave.

As we reported last week, Fedex tumbled after it reported that not only did it miss Q1 earnings - just hours after announcing it was raising prices at the fastest pace in decades - but also slashed guidance, warning about sharply higher labor costs and operating expenses.Picking up on this, earlier today Nordea also chimed in saying that "FedEx adjusted down expectations and cited being 35% understaffed in various parts of the supply chain as an important reason why. This is not good!" Yes... after the fact.

We won't waste our readers' time on why margins are set to plunge, and drag profits along with them absent a continued surge in revenues - we have discussed that extensively in the past few months - but we will highlight a recent note from SocGen's Andrew Lapthorne who cuts through the noise and says that corporates now have to make a decision: defend high margins or absorb "transitory" shocks.

As Lapthorne writes last week, while the rest of the world's attention turns to China, his charts focused on corporate profitability given the concerns about rising costs, supply disruption and now higher energy costs. According to the SocGen strategist, reported EBIT growth in the US has jumped by over 30% and over 55% in Europe, a remarkable surge which has been accompanied by a sharp increase in profit margins as sales growth has easily outstripped the growth in costs. Indeed, as noted recently, US profit margins hit an all all-time high in Q2, leading to a substantial uplift in profit margins to all-time highs.

Why the focus on margins and profitability? As Lapthorne explains, "profit margins act as shock absorbers. If businesses can absorb price shocks and business disruption into their P&L instead of passing the problems onto customers then logic has it that short-term profitability would be hit, but bigger issues, such as the need for policy tightening, is reduced."

And while on aggregate profit margins are healthy enough - for now - to absorb some temporary pain, it will be interesting to see what path the corporates take: to defend margins and risk inflation taking hold, or allow profits suffer for a while?

Tyler Durden Sun, 09/26/2021 - 17:30
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