What are investing style factors, and how can you use them to improve the returns on your stock portfolio?
Both are excellent questions. Style factors are different ways to slice and dice approaches to the market. Many investment funds draw a distinction between styles and factors and consider styles to be different strategic approaches to investing such as value, growth, momentum, quality, or volatility while factors have distinct risk-reward profiles. These terms are often used interchangeably which can confuse the discussion.
Style and factors can be used for investment approaches to different asset classes such as stocks, fixed interest, and other asset classes. For our purposes, we are considering stocks and we can slice and dice our market approach in different ways.
In the most fundamental way, we can build our portfolio with a mix of different assets. From a US perspective, the main asset classes are:
- US stocks
- International stocks
- fixed interest assets
When we compare the return on these broad asset classes we get a ranking in order of relative strength. This ranking tends to stay fixed for significant periods of time. During bull markets, US stocks and international stocks tend to be high on the list especially when interest rates are low. When interest rates are high then fixed interest assets will come high up on the list.
Where we are right now
Right now, late in 2020 interest rates are at an all-time low so fixed interest assets are not doing well. Actually, people who rely on income from fixed interest assets are losing hand over fist. At this time US stocks lead the pack.
What this means in simple terms is that if you want the best returns currently available, you need to be investing in stocks.
The world’s stock markets trade shares in thousands of companies which range in market capitalization from the low hundreds of millions of dollars to the trillion-dollar-plus capitalization of the mega-cap stocks like Amazon, Apple, and Microsoft. The market divides capitalization into a few categories:
- Large-cap above $10 billion
- Mid-cap from approx $2 billion to $10 billion
- Small-cap from approx $300 million to $2 billion
You could also say that the mega-cap stocks are in a class of their own, but so that we can model these categories using ETFs we will stick with the above three designations. The above categorizations are what most institutions and fund managers work with.
Stocks in these different capitalization groups behave differently. When we watch the indexes that track these different capitalization levels we frequently see different returns, whether on a daily, weekly, or monthly, etc basis.
There are also seasonal patterns frequently observed in the returns on the stocks with different market capitalization. Traditionally, conventional wisdom says that for most of the year small-cap will outperform the other two except during the last quarter when small-cap usually falls out of favor.
This is often attributed to institutional fund managers seeking higher risk and higher returns earlier in the year, and then wanting to be less aggressive in the last quarter taking risk off the table to defend their gains and hence their annual results.
For our purposes, the point is that investing in different market capitalization groups constitutes an investing style factor.
What about micro-caps?
There are also micro-cap stocks to consider. Penny stocks that have a stock price of less than $1 are often also micro-cap. But investing or trading micro-cap and penny stocks is a different ball of wax. It is a domain in its own right. These very small-capitalization stocks trade with very low volumes and higher bid/ask spreads that make them less liquid and more expensive to trade.
For the purposes of this article, we will leave micro-cap stocks to one side. However, from my experience micro-cap stocks in the upper range of their market capitalization band, i.e. from about $150 million to $300 million can be liquid and traded at a reasonable cost especially if you hold them for more than a year.
These stocks can also experience dramatic price rises and while most institutions have to ignore them because the position sizes they work with would cause big shifts in price, it can be a fertile field for retail investors. More on that another time.
Growth vs value vs quality
We have looked into three broad investing approaches in other articles, namely value, quality, and growth. These different approaches appeal to different kinds of investors. There are value funds, quality funds, and growth funds each following those distinct strategies.
In broad terms value investing looks for stocks that the market has currently undervalued on the assumption that in the future the true intrinsic value will be reflected in the stock price. Quality investing looks for high-quality stocks also looking for intrinsic value but considers the quality primarily and is less focused on whether a stock is currently undervalued or not. Value and quality investing rely heavily on fundamental analysis to research the intrinsic value of companies.
Growth investing focuses more on how the market favors some stocks over others and looks to take positions in stocks whose market valuations are set to appreciate. Growth investing pays more attention to technical analysis though most growth investors will not entirely discount value considerations.
Combining the style factors
If we take our three market capitalization groups and the two strategies of value and growth, that gives us a total of six different investment styles to compare. Namely,:
- Large-cap growth
- Large-cap value
- Mid-cap growth
- Mid-cap value
- Small-cap growth
- Small-cap value
We can also find ETFs that follow each of these strategies. These are a number of investment groups that have funds that fall into these categories, but for the sake of consistency and to ensure a clear distinction between the funds, it makes sense to consider ETFs from the same group. For the sake of this article, we will consider the ETFs of the iShares group. Here they are:
I’ve used the same color-coding system that I will use in later charts for consistency.
Ranking over time
What happens if we look back over the last ten years and see how they performed against each other.
At first glance, it looks as if they all pretty much follow the same path with Russel 1000 Growth, i.e. the large-cap growth fund outperforming the others.
But then when we look closely we see that other funds lead the field at different times.
For the first 8 or 9 months of 2015, small-cap growth was in the lead, and from around November 2016 until about March 2017 small-cap value was the leader.
This confirms what fund managers and many investors know, in any given year, one style of investing beats the others, but the next year a different investing style wins out. Let’s see what happens if we rank each of these funds against each other for each of the ten years restarting everyone from zero at the beginning of each year.
Ranking over annual periods
Here are the annual returns of each of the six investing style factors.
1)Historical stock data source: Yahoo finance, calculations, and charts by badinvestmentsadvice.com
Looked at like this it is a confusing array of numbers. To get an idea of what is going on let’s see how the funds rank each year showing the best performer on the left and the worst performer on the right.
Now we have something we can work with.
Let’s compare how different portfolios would have performed by different mixes of these funds. Let’s examine the approaches listed here. We will look at the annualized returns of the 10-year period from 2010 to 2019:
- Holding each fund for the whole 10-year period
- Holding the best performing fund from the previous year, for 10-years
- Holding the worst performing fund from the previous year, for 10-years
- Holding the two best performing funds from the previous year and rebalancing the portfolio each year, for 10 years
- Holding the two worst performing funds from the previous year and rebalancing the portfolio each year, for 10 years
Since we will need prior year data for all years including 2010, we will need the annual returns of each fund for 2009. It turns out that in 2009 all the funds had an excellent year coming out of the market crash of 2008. The results for 2009 were:
- Large-cap growth, IWF: 36.77%
- Large-cap value, IWD: 19.42%
- Mid-cap growth, IWP: 46.60%
- Mid-cap value, IWS: 33.75%
- Small-cap growth, IWO: 35.03%
- Small-cap value, IWN: 20.90%
Here is what each of those approaches would return over that 10-year period.
1. Holding each fund for 10-years
For this 10-year period, overall growth beat value in all cases, and large-cap growth beat both mid-cap and small-cap growth respectively. The average return of these funds was 234.10% over the 10-years.
2. Holding the best performing fund from the previous year.
Following this strategy, these are the funds we would have held in each year.
As we can see, holding the best performing fund from the previous year gave us a compounded return over the 10-year period of just 189.95% which is only marginally better than the worse performing fund, the small-cap value which returned 170.08% over the 10-years.
3. Holding the worst performing fund from the previous year.
This would be the list of funds we would hold, following this strategy:
So, this approach achieved a reasonable return of 216.24% over the 10-years, but that isn’t as good as the average of the individual funds and nowhere near as good as the best fund.
4. Holding the 2 best funds from the previous year.
With this approach, these would be the funds held each year, the average return of those funds, and then the results compounded over 10-year.
This approach achieved a compounded return of 197.12% which again is not as good as the average return of each of the funds.
5. Holding the 2 worst funds from the previous year.
The returns from the last strategy from our list are shown here.
In this case, we see a compounded return over the 10-year period of 270.32%. Though not as good as the best performing fund, this is an improvement on the average 10-year return of 234.10% of the funds.
Considering longer periods
To test these ideas further we should look at the performance of these funds over a longer period.
Taking the best performing fund, the large-cap growth fund IWF, since its inception in May 2000 to date, it has achieved a total return of 259.58%. That equals an annualized return of just 4.76%. So actually for the first 10 of those years, it didn’t do well at all and for the last 10-years, it did particularly well. As we can see from its chart this fund languished in negative territory from its beginnings until some time in 2012 and only then did it take off.
To me, this demonstrates the need to use long time frames to assess the performance of a fund.
For the six investing style factor funds we have been looking at, given the results of the above study of how they perform using the five strategies, I think it makes sense to see how the same six funds perform if we invest in the three worst-performing funds from the previous year as a sixth strategy to try.
6. Holding the 3 worst funds from the previous year
Here are the results of that study:
Well, I’d say that was not entirely discouraging and not particularly exciting either. On the other hand, there is an important consideration that we have been ignoring so far and that is the variability of returns. From this perspective achieving this level of returns with greater diversification, we can see that the standard deviation of returns is steadily lower as we increase the number of funds.
The differences are small but as with all things that relate to long-term investing, consistent small percentages will make a significant difference over time.
Even further analysis
If I were to investigate this approach further, I would look at comparing and ranking quarterly results and six-month results. After all, there is no reason why annual periods should be a sweet spot and funds are reported quarterly so looking for relationships over this time frame makes sense.
Nevertheless, this analysis of investing style factors has demonstrated how they can be used to improve portfolio performance and reduce the variability of results.
Q. What are the important style factors in investing?
A. The important investing style factors are: Value, growth or momentum, quality, volatility, and in the case of stocks, market capitalization can also serve as a style factor.
Q. Are investing style and factors the same thing?
A. Not really. Investing style usually means an investing strategy, while factors mean attributes of different assets within an asset class that have similar qualities in terms of risk and reward.
Q. Which factors offer the highest returns?
A. The simple answer is it depends. Some studies show that a value approach offers the highest assured reward over the long-term. Other studies show that a growth strategy offers higher rewards albeit with higher risk.
I hope you found this article interesting and useful. Do leave me a comment, a question, an opinion, or a suggestion and I will reply soonest. And if you are inclined to do me a favor, scroll down a bit and click on one of the social media buttons, and share it with your friends. They may just thank you for it.
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|↑1||Historical stock data source: Yahoo finance, calculations, and charts by badinvestmentsadvice.com|