2018 Market Outlook – Factors

Factor Background

One of the prisms through which we analyze market and manager performance is that of common risk factors. A risk factor is a characteristic that is common to a broad universe of stocks that has three primary attributes:

  1. The factor must generate persistent long-term excess returns,
    a. Is the factor successful in many market environments and across market segments and asset classes?
  2. Is well-supported by financial economic research,
    b. Does the factor work not only in-sample but also out-of-sample?
  3. Has a reasonable and rational intuition behind it.
    c. Is there a risk-based or behavioral explanation as to why the factor works?

While there have been literally hundreds of factors identified by academic researchers over the past few decades, only a handful has been shown to be statistically robust over time. In addition to the Market factor, these well-known factors include:

Size: The tendency for smaller cap stocks to outperform larger cap stocks.

Value: The tendency for inexpensive stocks to outperform expensive stocks.

Momentum: The tendency for recent winners to continue to win on a relative basis.

Quality: The tendency for more profitable and less leveraged companies to outperform those that are less profitable and more leveraged.

Low Volatility: The tendency for stocks with lower beta and idiosyncratic volatility to outperform those with higher volatility.

Factor Performance in 2017

Factor performance in 2017 was mixed. The top performing factor across equity asset classes was momentum, which could be expected in such a low volatility environment in which stock prices posted strong gains. The idea behind momentum is that winning begets winning, and the market landscape was perfectly suited for momentum last year.

  • Momentum in the emerging markets asset class was especially strong, with high momentum stocks outperforming low momentum stocks by almost 2000 basis points during the year.

Quality also performed well in all asset classes except small cap. This is a similar story to momentum, in that at this point in the market cycle investors typically look for companies with sustainable profit growth, and profitability is one of the core elements of the quality factor.

The other major factors did not fare as well. The poorest performing factor in 2017 was value. As often happens, value’s performance mirrored that of momentum, and the market environment was not one that historically favors value-oriented stocks. The value factor in the small cap segment was by far the worst performing factor in 2017, generating a -9% return. And value’s underperformance among small caps was also evidenced in market indexes, as the Russell 2000 Value index underperformed the Russell 2000 Growth by more than 1400 basis points for the year.