An Introduction to Factor Investing: Understanding the increasingly popular strategy

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1 A quarterly publication of CLS Investments FALL 2015 An Introduction to Factor Investing: Understanding the increasingly popular strategy Factors have engrossed the investing world in recent years. Strategies previously reserved for institutional investors are now available to individual investors through low-cost ETFs. This issue of Directions serves as an introduction to factors, and will hopefully provide a background for other factor investing publications from CLS or others. About the Author Grant Engelbart, CFA, joined CLS in 2009 as a trading specialist, and has since held various roles in multiple departments. In 2013, he accepted the role of Portfolio Manager and currently serves as the manager and co-manager for multiple funds and strategies. Prior to Joining CLS, Mr. Engelbart held positions at TD Ameritrade and State Street Corporation. Mr. Engelbart received his Bachelor s degree in Finance from the University of Nebraska at Lincoln. He holds the Chartered Financial Analyst (CFA) designation and FINRA Series 65 license. An Introduction to One of the Fastest Growing Investment Trends Lately, one of the hottest topics in investment literature and product development has been the rise of factor investing. This has been intensified by the launch of factor-based products from ETF firms. Factors can seem like a bunch of confusing financial mumbo-jumbo, but taking some time to look at exactly what factor investing is can help to clear things up. When used properly, factor investing can lower risk and improve returns a welcome combination. There has been extensive academic research discovering and studying factors, which are typically defined as sets of common characteristics between securities that define their risk and return. Factor investing has historically been reserved for institutional investors, but through the growing adoption of ETFs, individual investors are now able to access these factors at exceptionally low costs. There are five widely studied factors we will look at in more detail: value, size, momentum, low/ minimum volatility, and quality. 1

2 Value One of the most common and foundational methodologies in finance (and beyond) is value investing buying an asset that is trading below its perceived fundamental value. Value approaches typically use price multiples such as priceto-earnings or price-to-book in order to screen for stocks that are undervalued. Size The size factor is the return premium earned by smaller companies relative to larger ones. Smaller companies are generally thought to have more risk and less access to financing, which demands a higher return for investors as compensation. Size is measured by market capitalization. Equal weighting often captures this factor as it tilts toward smaller companies. Momentum Momentum is the idea that stocks that have done well in the past will continue to do well into the future. Generally it is thought that momentum exists because people tend to over- and under-react to new information, extrapolating returns into the future. Usually 6- and 12-month returns are used when screening for momentum. Low/Minimum Volatility Low-volatility securities are those that have lower measured volatility than others. Typically, volatility is measured by standard deviation, or sometimes beta. Traditional financial theory suggests that stocks with lower risk should underperform those with higher risk, not outperform. However, low volatility stocks have tended to outperform over a full market cycle, with less risk. Minimum volatility is another variant of the same phenomenon. Quality Higher-quality stocks also tend to outperform over a full market cycle. While it may seem obvious, defining quality can take many forms, such as dividend growth,return-on-equity (ROE), low debt, and even a wide economic moat. Quality has been a key CLS theme for the past two years, and it is one of the factors we have been tilting portfolios toward lately. We have written extensively about quality, including in a past issue of this very publication, and even created a strategy focused Return (Annualized) on high-quality assets. Factors have historically provided long-term excess returns (excess meaning aboveand-beyond the return of the market). However, there are a couple of important points to this. First, factor returns are cyclical. Not all factors work at the same time, not even close. For instance, the momentum factor worked wonders in the late 90 s, riding tech stocks higher while value suffered. As the tech bubble burst, the tide changed. Related to this is the fact that some factor returns are not correlated to each other, which is why pairing certain factors (like the aforementioned momentum and value) makes a lot of sense. Second, factors have different risks. As you can see in the plot below, minimum volatility (far left) has significantly less risk than momentum but very close Historical Risk and Return Select Global Factors 1/1/1999-8/31/2015 Minimum Volatility Quality Momentum Risk (Standard Deviation) Source: Morningstar, MSCI Size All-Country World Index Value 2 FALL 2015

3 to the same return. Minimum volatility and quality tend to be more defensive, while momentum, value, and size are more aggressive. This further lends credence as to why the combination of multiple factors is important. At CLS, we have embraced the use and measurement of factors within our strategies. Interestingly, whether investors are using factor-based funds/ ETFs or not, they always have some kind of factor exposure. Measuring and understanding that exposure is as (if not more) important than understanding any kind of traditional investment risks and exposures. For example, knowing how much you re invested in Apple is as important as knowing how much exposure you have to momentum stocks. Factors Lately This year has seen two very different halves. The first half of the year was marked by small but steady gains, while more recently, markets experienced % Return 0% -1% -2% -3% -4% -5% -6% -7% Value -6.8% -8% Source: Morningstar, MSCI, Returns through 9/21/2015 their first 10% correction since Factor performance has been mixed (which is what you would expect!). More defensive factors such as quality and minimum volatility have held up well, while more aggressive factors such as value and size haven t done quite so well. The graphic above shows global factors, based on the MSCI All- Country World Index (ACWI). Historically, there has never been a one-year period where at least one factor hasn t outperformed the MSCI ACWI, especially in Global Factor Performance 2015 Size -5.7% All-Country World Index -4.4% Quality -2.8% down periods. Momentum Minimum Volatility -0.9% -0.8% Factor investing provides another lens through which to view portfolios. The risk management benefits of understanding factor exposures fits perfectly with CLS s Risk Budgeting Methodology. As the investment landscape changes, you can count on CLS to adapt and grow while staying true to our commitment to building global, balanced, risk budgeted portfolios that can help you succeed. FALL

4 2015 Investment Themes from CLS Chief Investment Officer, Rusty Vanneman, CFA HIGH QUALITY We are emphasizing high quality companies in our domestic equity ETF holdings as these companies should do better in the latter stages of a bull market. In defining high quality, we like companies that have relatively stable profitability, strong balance sheets, and higher dividend growth. EMERGING MARKET OPPORTUNITIES We believe that strategically incorporating international securities, including emerging markets, in a portfolio provides additional opportunities to enhance long-term risk-adjusted returns. In addition, from a tactical perspective, many emerging equity markets are sporting far more attractive valuations than the U.S., suggesting that future returns will be higher overseas than they will be domestically. TECHNOLOGY/INNOVATION The technology sector offers one of the most attractive opportunities within domestic equities. Besides having some of the companies with the highest quality ratings (i.e., strong balance sheets and profitability), the relative valuation of technology remains among the cheapest of the economic sectors. TACTICAL FIXED INCOME We believe bond returns will likely be below average in the years ahead. In turn, we will actively manage our fixed income holdings. For instance, we may rotate between duration, credit, inflation break-evens, and international holdings to give us an opportunity to take advantage of changes in bond market relative valuations. 4 FALL 2015

5 Investing Through the Emotional Ups and Downs Scott Kubie, CFA CLS Chief Strategiest Markets are often more volatile in the fall, which we ve experienced the past few weeks, and has sent a few investors scurrying to cash. Before letting the recent volatility push you over the edge, here are a few things I use to help maintain perspective: Bearing volatility is what we get paid to do. Putting up with the risk is what generates the opportunity for higher returns. Stocks have earned more than Treasury bills because there are opportunities for the investments to go down, allowing investors to buy low and sell high. Three. That is the number of days the S&P 500 has been down more than 10% from its high in For the returns in recent years, three days in correction territory doesn t seem like too much to suffer through. It s 2015, not The excesses that drove the 2008 real estate market have lessened. Economic growth doesn t point to a recession or hyper-inflation right around the corner. It s 2015, not The emotional reaction reflected in market prices in 2009 is in the past. Investing risk has two basic sources: business risk and investor risk. Investors contributed a lot of risk to the market in 2009, so the rewards were very high. In recent years, we ve seen low volatility because businesses have done well and investors have stayed the course. Expect businesses and investors to add more volatility in future years. Don t look at your portfolio values too often. While I know how the market fared each day, I don t look at my portfolio more than once per month. The average risk budget of my accounts is around 90, so if the market is down 7%, I expect to be down around 6%. No point in checking on it every hour. When you do look, think about your portfolio in terms of percentages rather than dollars. Dollars are emotional, percentages less so. If an 8% decline causes your portfolio to drop $100,000, it means you are still a millionaire. Putting the moves in terms of percentages makes the ride easier. Don t switch from watching your portfolio to watching the news. My experience is investors who watch the news get more nervous in down markets. Constant breaking news raises the emotional temperature. I ve found investors who follow markets or politics closely are more likely to panic. If your portfolio doesn t cause you a little concern, you might be invested too conservatively. Assuming markets go up over the long run, investing too conservatively can cost far more than the losses that come from corrections. What should you do if you are still nervous? Take a break from thinking about your portfolio, and do something else that gets your attention. Or, get in touch with your financial advisor who can help explain market activity and keep you on course. FALL

6 The views expressed herein are exclusively those of CLS Investments, LLC, and are not meant as investment advice and are subject to change. No part of this report may be reproduced in any manner without the express written permission of CLS Investments, LLC. Information contained herein is derived from sources we believe to be reliable, however, we do not represent that this information is complete or accurate and it should not be relied upon as such. All opinions expressed herein are subject to change without notice. This information is prepared for general information only. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. You should seek financial advice regarding the appropriateness of investing in any security or investment strategy discussed or recom mended in this report and should understand that statements regarding fu ture prospects may not be realized. You should note that security values may fluctuate and that each security s price or value may rise or fall. Accordingly, investors may receive back less than originally invested. Past performance is not a guide to future performance. Investing in any security involves certain systematic risks including, but not limited to, market risk, interest-rate risk, inflation risk, and event risk. These risks are in addition to any unsystematic risks associated with particular investment styles or strategies. The graphs and charts contained in this work are for informational purposes only. No graph or chart should be regarded as a guide to investing. An ETF is a type of investment company whose investment objective is to achieve the same return as a particular index, sector, or basket. To achieve this, an ETF will primarily invest in all of the securities, or a representative sample of the securities, that are included in the selected index, sector, or basket. ETFs are subject to the same risks as an individual stock, as well as additional risks based on the sector the ETF invests in. The MSCI ACWI captures large and mid cap representation across 23 Developed Markets (DM) and 23 Emerging Markets (EM) countries. The S&P 500 Index is an unmanaged composite of 500-large capitalization companies. This index is widely used by professional investors as a performance benchmark for large-cap stocks. An index is an unmanaged group of stocks considered to be representative of different segments of the stock market in general. You cannot invest directly in an index. High quality investments are investments in securities issued by companies with the propensity for higher than average characteristics including higher and more consistent profitability, stronger balance sheets, and higher dividend growth. The primary diversifiable risk is opportunity risk. Emerging market investing refers to the practice of investing in a developing market of a foreign nation. The pre-requisites of this practice include a market within the foreign nation along with some form of regulatory body. Emerging markets involve greater risk and potential reward than investing in more established markets. Diversifiable risks for emerging markets include, but are not limited to, political risk, currency risk, and liquidity risk. The technology, or information technology, sector is a sector representing enterprises engaged in the research, development, or distribution of technology goods and services. Examples include electronics manufacturers, software creators, computer manufacturers, etc. Fixed Income is an investment style designed to return income on a periodic basis. Generally, fixed income strategies invest in bonds, real estate, loans, and other types of debt instruments. Diversifiable risks associated with fixed income investing include, but are not limited to, opportunity risk, credit risk, reinvestment risk, and call risk CLS-10/2/ FALL 2015