Factor Fitness: Understanding Equity Exposures

by Walt Czaicki, Scott Krauthamer, AllianceBernstein

Equity factors are increasingly used by investors to help guide their portfolio allocations. So it’s important to have a good grasp of what factors are and how they perform through an economic cycle, in order to invest effectively.

Choosing the right equity portfolio is a very personal matter. Individual tolerances for risk, and return expectations, are usually the starting point. Personal views on stock market patterns, the earnings environment, corporate and industry trends, and increasingly the macroeconomic outlook also shape an equity allocation decision. These days, finding a portfolio that reflects an investor’s views often draws on equity factors.

Three Broad Categories

But what does factor investing really mean? Simply put, factors are characteristics of stocks that are associated with higher return potential, and are usually grouped into three broad categories:

• Size—e.g., smaller companies with a market capitalization of typically $5 billion or less, versus larger-cap stocks
• Style—growth companies with high year-over-year earnings growth, as compared to value stocks with low price-to-book-value ratios
• Risk—low-volatility stocks have lower beta than the market, meaning their performance is typically more stable than that of the benchmark; they can provide protection in market downturns

Of course, using factors to guide investments isn’t new. Style investors, for example, have used value and growth factors to help construct portfolios for decades. Maintaining exposure to both value and growth stocks helps smooth return patterns, as their factor returns tend to perform best in different periods.

The Smart Beta Boom

What’s changed in recent years is the technology that underpins factor-driven portfolios. The expanding universe of smart beta portfolios relies heavily on quantitative factor measures in order to calibrate exposures. Technology has enabled the creation of thousands of factor-based, or smart beta, portfolios that enable investors to buy exposures to stocks that favor characteristics such as high growth or low volatility, as well as a multitude of esoteric equity flavors.

That’s where the problems begin. While it’s relatively easy to apply factors in both active and passive portfolios, many investors aren’t aware of how factor exposure can affect performance patterns. And although quantitative tools drive the construction of factor-based portfolios, the factors themselves are subject to fundamental market forces; they don’t exist in a vacuum.

Economic Cycles Matter

Factors are especially influenced by the macroeconomic cycle. For example, our research suggests that small-caps and value stocks tend to do best during the recovery phase of an economic cycle (Display), when corporate profits tend to increase broadly. Growth and high-quality factors perform best as the economy expands and then moderates, as corporate profits become more scarce. In contrast, lower-volatility factors tend to lag behind other factors in recovery periods, while outperforming during a contraction.

As a result, factor leadership is constantly changing—sometimes dramatically (Display). Stocks with momentum and growth exposure have led the pack this year, in a sharp reversal from 2016, when small-cap and value stocks outperformed. Low-volatility factors were strongest in 2011 but fell to the bottom the following year.

These fluctuations highlight why understanding factor exposures is essential to managing return expectations. Yet many investors don’t really know how to gauge their portfolio exposures, which means they could be in for unpleasant surprises if the environment shifts against them.

Knowing the factor profile of an equity portfolio can help investors position and prepare. Investors who have a clear view on the direction of the economy can use factors to find the most suitable portfolio for the environment. For investors who don’t have a strong opinion on the economic cycle, understanding factors can help diagnose a portfolio’s vulnerabilities to potential shifts in market conditions and adjust exposures for different outcomes. Determining a portfolio’s factor fitness is essential to ensure that an equity strategy is in line with an investor’s long-term goals and expectations.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.

MSCI makes no express or implied warranties or representations, and shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any securities or financial products. This report is not approved, reviewed or produced by MSCI.

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