More on Investment Factors
Last week, I introduced the new Factor Edge and detailed the 11 investment factors I would be tracking and commenting on each week. Some people were surprised that my list contained more than the four or five factors that most multifactor ETFs currently utilize. Others observed that I left out a few. Indeed, many investment factors did not make the list of 11 because there are no ETFs tracking them, or because the ETFs that do track them are relatively new or small in size.
Today, I will discuss a few other investment factors that are on my radar, starting with those that already have ETFs representing them:
- Earnings/Profitability: Weighting stocks based on their earnings (revenue – expenses) is the factor employed by WisdomTree Total Earnings (EXT).
- Revenue: The Oppenheimer Large Cap Revenue (RWL) weights its holdings by revenue (sales).
- Low Beta: Often confused with the Low Volatility factor, Low Beta includes a correlation component to identify stocks with low sensitivity to market movements. The PowerShares Russell 1000 Low Beta Equal Weight (USLB) also equal-weights its holdings.
- Intrinsic Value: The Diamond Hill Valuation Weighted 500 (DHVW) holds 500 of the largest U.S.-listed equities weighted by their intrinsic value capitalization.
- Investment: The Elkhorn S&P 500 Capital Expenditures (CAPX) looks at the efficiency of corporate investments in future growth by looking at sales to capital expenditure ratios.
- Capital Strength: First Trust Capital Strength (FTCS) includes only companies with at least $1 billion in cash, a long-term debt-to-market-cap ratio less than 30%, and a return on equity greater than 15%. It is similar to the Quality factor.
- Customer Satisfaction: Customer satisfaction is a predictor of a company’s future growth and profitability and is the factor employed by the American Customer Satisfaction Core Alpha ETF (ACSI).
- CAPE: The Shiller CAPE ratio is a cyclically adjusted price-to-earnings ratio that smooths out the swings of the business cycle. Although it is a popular investment factor, only the Barclays ETN+ Shiller CAPE ETN (CAPE), an exchange-traded note, uses it.
These eight factors, combined with the 11 discussed last week, put the factor count at 19. Is that all of them? Not even close. In the research paper “…and the Cross-Section of Expected Returns,” authors Harvey, Liu, and Zhu identified more than 250 investment factors in published research. That was at the end of 2012, and the quantity has undoubtedly grown since then.
Additional factors of interest to me, for which there are not any ETFs at the present time include the following:
- Alpha: Alpha, the risk-adjusted outperformance against a benchmark, seems to be the most obvious. Everyone wants alpha, so why not use stock alpha as a selection factor. This is similar to the Momentum factor.
- Earnings Momentum: This was a key factor employed by successful aggressive growth managers in the 1990s. It fell out of favor when the dot-com bubble burst, but it still has a lot of potential.
- Book Value: Book value is the denominator in many “value” ratios. Since it is such an important component, perhaps it should be isolated.
- Drawdown: Many risk factors are easy to measure, and Volatility (standard deviation) seems to be the most prevalent. However, for many investors, the amount a stock has previously declined, Drawdown, is a more important factor.
- Downside Deviation: Downside deviation is similar to the standard deviation measure used in the Volatility factor. The difference is that Downside Deviation ignores all upward movements and calculates the standard deviation only on down days.
When it comes to multifactor investment strategies, it is easy to see that the permutations and combinations of investment factors are infinite, especially when you realize that each factor does not have to have a static or equal weighting within a strategy. This may come as a shock to those that believe that all possible ETFs that can be invented have already been invented.
Technology and Financials are the only two sectors able to post positive momentum scores today. Energy was part of this positive group a week ago, but it is now one of the nine categories in a downtrend. Utilities was able to squeeze out a fractional gain, while all other sectors lost ground for the week. This relative strength showing by Utilities boosted its ranking five places to third. Real Estate underwent the most pain, pushing it one spot lower to 10th, and it is now deeply in the red. Health Care remains on the bottom for a second week.
High Beta is the only factor in the green this week, as five others shed their positive momentum scores. Relative strength in High Beta is usually associated with aggressive upward market moves, so it is unusual to see it at the top when stocks are clearly shifting toward a defensive stance. Unless the tenor of the market changes dramatically and quickly, we would expect High Beta to fall in the rankings in the coming weeks. Value, Fundamental, Market Cap, Growth, and Size gave up their small slivers of positive momentum. Although they lost “absolute” strength, Value, Quality, and Yield moved higher in the relative-strength rankings, indicating a defensive shift. Size plunged from second place to ninth as investors dumped small-cap stocks. Dividend Growth slipped below Low Volatility to claim the bottom spot.
Although there were 10 last week, six global categories remain in the green, showing that most of the market strength currently resides outside the borders of the United States. In fact, the U.S. slipped another notch lower to 10th place, with the U.K. being the only major global category in worse shape. Latin America declined this past week, but it is still heads above the crowd. Japan improved from fourth to second, yet remains far below Latin America for now. China, formerly in second place, was pushed down to fifth by the rise of Japan of Canada. Pacific ex-Japan, EAFE, World Equity, and the U.S. moved from green to red, while U.K. kept its solid lock on last place.
“The advancement of the arts, from year to year, taxes our credulity and seems to presage the arrival of that period when human improvement must end.”
—Henry Ellsworth, Commissioner of the U.S. Patent Office (1843)
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