2014 Global Factor Round Up
January 27, 2015
by Michael Nairne
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One of the most important discoveries in finance over the past few decades is that stocks of firms that share certain fundamental characteristics called “factors” exhibit different return and risk characteristics than the overall market. Critical to investors is the fact that, over long periods of time, certain of these factors have earned excess returns compared to the overall market.
Broadly speaking, these factors can be distilled into the following categories:
- Value: Stocks that are low-priced in relation to earnings, dividends, cash flow or book value, on average, have outperformed growth stocks over long time horizons.
- Size: Stocks of small and mid-size companies have earned, on average, higher returns than stocks of large companies over long time periods.
- Momentum: Stocks that have exhibited positive momentum – i.e., have performed relatively well over the past 3 to 12 months – have outperformed, on average, over long time horizons stocks that display negative momentum.
- High Yield: Stocks of companies that pay higher dividends, on average, have earned superior returns to lower and non-dividend paying stocks over the long run.
- Quality: Stocks that have evidenced superior profitability in relation to capital have outperformed, on average, firms with poorer profitability in relation to capital over long time horizons.
- Low Volatility: Stocks that have exhibited low volatility have, on average, outperformed stocks that display high volatility over the long run.
There are two primary explanations for the higher returns associated with these factors. One is that the higher returns represent risk premia – i.e., compensation to investors for incremental risks beyond that of the total stock market. For example, small company stocks are not only more volatile than stocks of large companies but are also much less liquid. Value stocks tend to include a higher proportion of heavily indebted companies which dramatically underperform the overall market during periods of extreme market stress.
The second explanation is offered by behavioral finance. Investors’ cognitive biases such as “myopia” and “overconfidence” can lead to the persistent mispricing of certain securities. For example, many investors, attracted to the episodic outsized returns of high volatility and low quality stocks, chase these types of stocks despite a pattern of long-term underperformance. Overly optimistic investors overestimate the earnings prospects of growth stocks while underestimating those of value stocks; value stocks then generate superior returns as investors eventually realize that earnings in the value universe are better than initially expected.
Social phenomena such as the “bandwagon effect” can also distort prices. The “madness of crowds” – as evidenced by the railway mania of the 1840’s, the Florida real estate boom of the 1920’s, the Japanese bubble of the 1980’s and the dot.com mania of the 1990’s, is a well-documented recurring market spectacle. The herding behavior of investors has also been advanced as an explanation for the returns associated with the momentum factor.
Factor performance can vary as a result of business cycle influences, market sentiment, interest rate changes, sector composition and other variables. The following chart sets out the return earned by each factor globally in 2014 compared to the overall broad market. (See Appendix I for Sources.)
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