Four-Factor Investing: Quality, Value, Momentum, and Size
Recently, we streamlined and enhanced our core investing strategy and moved from a three-legged stool to a four-legged chair. And, while we can make no guarantee of future results, we are staying with our new four-legged chair model for the foreseeable future. Why? We wanted to make it possible for our clients to tailor an investment strategy to match their unique goals, interests, and values. By adding a fourth factor to our existing factor-based investing, we’ve made a proactive expansion of our strategy in order to best serve the interests of our clients.
This article will serve as the first in a series designed to break down exactly how our enhanced approach, built upon our existing client-focused framework, will help you put a little more YOU in YOUR portfolio.
Four-Factor Investing Strategy: Expanding, Not Replacing
Our three-legged stool model focused on three main factors: Quality, Value, and Size. We have added Momentum as our fourth factor, which we believe makes for a strong combination for our risk-adjusted portfolio strategy. I want to take a moment to share what each of these factors means for investors:
Investing Strategy: Quality
The tendency for higher quality companies – those that are more profitable and safer – to outperform lower quality companies. Higher quality companies tend to have a consistent return on investment and thus provide some safety in a portfolio.
Investing Strategy: Value
The tendency for cheap assets to outperform expensive assets. There have been a number of studies comparing the long-term performance of value stocks to growth stocks demonstrating the excess returns of value stocks over time.
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Investing Strategy: Size
The tendency for smaller capitalization stocks within a universe to outperform larger capitalization stocks. Smaller capitalization stocks, especially those that demonstrate the Value characteristic, have provided excess returns over larger capitalization over time. (Note that smaller cap stocks are less efficient, less widely followed and less liquid. Hence, they do carry additional risks.)
Investing Strategy: Momentum
The tendency for assets that have performed well over the past year to continue to perform well over the near term. In other words, winners continue to win, and losers continue to lose. Value and Momentum are two of the most extensively researched factors and work well in combination due to their negative correlation. This negative correlation provides an opportunity for the combination of these two factors to enhance risk-adjusted returns.
Factors of a Feather
Quality, Value, and Momentum have the tendency to complement one another, and we can see this from an economic perspective in their responses to phases of the business cycle. Quality, which tends to correlate to high-quality financials in companies, tends to perform better during a slower, defensive, economic cycle. With Value, the strategy is to buy into companies that are undervalued by the market, making them less expensive but also riskier. Their performance is more aligned with a low-risk economy with prospects for strong near-term growth. Momentum, whose performance is contingent on the notion that stocks that have been performing well will continue to do so, tends to show its strength later in the growth cycle.
The factors of Quality, Value, and Momentum exhibit low correlation due to their typical reactions to various business cycles from defensive, low-risk and later-stage growth. The combination of these factors tends to work well together with the goal of providing a smoother portfolio experience.
Each factor generates positive expected returns independently but when Value, Momentum, and Quality are blended, it is expected that the portfolio can deliver compelling risk-adjusted performance. Given the longer-term outperformance of smaller cap stocks, but the additional risks associated, this factor is incorporated in the portfolio to a lesser extent than the factors of Value, Momentum, and Quality through the use of an all-cap strategy to provide exposure to small-cap stocks in portfolio design.
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Factor-Based Selection Process
So, what does this mean for our client’s portfolios? When making portfolio selections, individual stocks are evaluated to determine those that exhibit the factors of Quality, Value, and Momentum, with a minor emphasis on Size. The most attractive stocks in each of the respective factors are ranked highest as candidates for overweight in the portfolio. The final allocation is then selected in a manner to provide proper diversification with allocation to sectors based on market weights. The resulting portfolio exhibits enhanced exposures to the factors having the highest expected returns.
The Four-Legged Chair
While there is a great deal of technicality here that may or may not have put you to sleep, one thing has been clear in making the determination to shift to our four-legged chair model: We have done our due diligence and feel confident that our new strategy will provide our clients with greater opportunities for growth while maintaining protection for all risk-adjusted investment portfolios. It always remains our highest priority to make decisions that are in the best interests of our clients.
If you or someone you know is interested in becoming a client of Resolute Wealth Advisor, or if you would like to sit down for a complimentary portfolio consultation, please contact us at firstname.lastname@example.org, (419) 422-4400, or select a convenient time here.
If you enjoyed this content and you’d like to learn more about our enhanced investment strategy, stay tuned for Article 2 in this series, in which we’ll discuss opportunities to invest in individual stocks and ETFs through separately managed accounts (SMAs).