A Sharper Lens – Factors & Sectors

Key takeaways

  • Factor investing can help drill through broad sector labels to help investors better understand past performance and expected returns.
  • Investors taking factor views may be better able to capture the underlying exposure they seek and obtain complementary views compared to traditional sector labels.
  • It’s not factors vs. sectors. It’s factors and sectors.

Sector classifications are useful for viewing companies in similar lines of business, but companies often have business lines that span multiple industries or sectors. For example, Amazon is one of the leading “FAANG” technology companies. It sells goods online, offers e-commerce services, streams music and video, produces media content, operates a cloud platform, has AI capabilities, sells consumer products like Kindle, Fire, Ring, and Echo, and offers medical services. According to the Global Industry Standard (GICS) sector definitions, Amazon is not in the technology sector. (It is defined as a Consumer Discretionary company.) While sectors can provide a high-level understanding of similar businesses, sometimes these definitions are too blunt an instrument.

At the same time, economic forces can make some stocks expensive or cheap, experience winning or losing trends, and be exposed to financial stress for more highly levered companies – simultaneously affecting stocks across different sectors. Factor investing drills through broad labels to highlight what investors may care about and to help understand past performance and expected returns. These characteristics include absolute and relative price (size and value), the quality of a company’s earnings, trends in company performance (momentum), and the absolute and relative risk of a company (minimum volatility).

Factor Returns

The five factors of value, quality, momentum, minimum volatility, and small size are all supported by empirical data and peer-reviewed research.1 These factors have not only shown positive excess returns or reduced risk in the initial research, but they have also survived out of sample. Historically, each of these five factors has outperformed its counterpart – large size, higher priced companies, less profitable firms, downward trending stocks, higher risk securities – over varying time periods.

Percentage of periods that factor outperformed counterpart

Investors can contrast factors with sectors or industries, which have not exhibited significant long-term excess returns above the market.2

Reward to Risk Ratio of Factors compared to Industries