LEADERSHIP SERIES Incorporating Factor Strategies into a Style- Investing Framework Passive investors can gain targeted exposure to value and growth companies with factor strategies. Darby Nielson, CFA l Managing Director of Research, Equity and High Income Bobby Barnes l Quantitative Analyst, Equity and High Income Matthew Horne, CFA l Director, Sector and ETF Investment Strategy Key Takeaways Passive investors who use a style framework to build portfolios can achieve targeted access to value and growth companies with factor strategies. Traditional style indexes may not offer pure exposure to value and growth stocks because they often must account for an entire stock universe. Value factor strategies can be more selective when identifying inexpensive stocks, so they often boast more targeted exposure to value companies. Many passive investors that use a style framework when building portfolios use traditional style indexes to gain exposure to value and growth stocks. These cap-weighted 1 style indexes can be constructed in a number of ways, and EXHIBIT 1: Value and momentum factor strategies plot within the same corners of the style box as passive style indexes. Style Indexes and Factor Strategies within a Style Framework Mid Large Value Core Growth Value Factor Value Style Index Momentum Factor Growth Style Index Size Momentum factor strategies have had higher realized earnings growth than traditional growth indexes over the long term. When combined, value and momentum factor strategies have the potential to provide more diversification than a combination of traditional value and growth style indexes, which simply offers broad-market exposure. Small Style Value style index = Russell 1000 Value Index; growth style index = Russell 1000 Growth Index; value factor = combined average ranking of stocks in the top quintile by book/price ratio and by earnings yield of the Russell 1000 Index; momentum factor = top quintile by trailing 12-month returns of the Russell 1000 Index. Factor portfolios are equal-weighted and sector neutral, assume the reinvestment of dividends, and exclude fees and other implementation costs. Average positioning from 2012 through 2016. Source: FactSet, Morningstar, Fidelity Investments, as of Dec. 31, 2016.
some are better than others at delivering pure exposure to value and growth stocks. But investors can target the same corners of the style box using factor (or smartbeta ) strategies, designed to capture stocks with certain fundamental characteristics (Exhibit 1). In fact, factor strategies may deliver purer exposure to value and growth stocks. (For more details on factors, see our Leadership Series article An Overview of Factor Investing. ) This article illustrates how factor strategies may be used within a style-investing framework, for investors who use this approach when building portfolios. We explore the differences between traditional style-index investments 2 and factor strategies, highlight the benefits of a factor-based approach to value investing for those seeking truly inexpensive stocks, and demonstrate that momentum factor strategies may be potential solutions for targeting growth-oriented companies. Lastly, for investors seeking enhanced diversification, we share the benefits of combining two factor strategies to create a more diversified core portfolio. This approach stands in contrast to combining traditional value and growth style indexes, (which can potentially offset one another), and can provide simple broad-market exposure without improved diversification. Traditional style indexes may not provide high-conviction growth and value exposure The style framework and style indexes were originally created so that active portfolio managers could be better classified against their specific investment styles or objectives, rather than against the broader market. Style indexes generally account for an entire universe of stocks across the value/growth spectrum, and classify them as one or the other or in some cases, both using some combination of value and growth metrics (Exhibit 2). But growth isn t simply the opposite of value, nor is the inverse EXHIBIT 2: Most style indexes account for an entire universe of stocks; therefore, every company in that universe will fall within either value or growth, and some may fall into both. Breakdown by Market Capitalization of a Style Index Example 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% % in Value % in Growth 19% 81% 50% 50% 92% 8% 1 101 201 301 401 501 Stock Ranking 601 701 801 901 General Electric Verizon Style index shown: Russell 1000 Index. Company names shown here are for illustrative purposes only and are not a recommendation or an offer or solicitation to buy or sell any securities. Source: FactSet, Fidelity Investments, as of Dec. 31, 2016. Apple 2
INCORPORATING FACTOR STRATEGIES INTO A STYLE-INVESTING FRAMEWORK true. Therefore, such an approach may not provide pure value and growth exposure. For example, it s possible for a stock to be inexpensive but to be growing quickly. Further, stocks within a value style index may not truly be inexpensive; they may just have weak earnings and be the opposite of growth stocks. Similarly, stocks within a growth style index may not be true high-growth companies; they may simply be expensive the opposite of value stocks. A preferred method for pure value and growth exposure would be to classify value stocks using only measures of value and to classify growth stocks using only measures of growth. The way a style index or factor strategy is constructed will determine what its underlying holdings will be, and in turn, what its performance might look like. Style indexes generally segregate stocks into either value or growth using some combination of book-to-price ratio and realized earnings growth. Moreover, due to their often overly simplified classification frameworks and inclusion of the entire stock universe, traditional style indexes may not provide high-conviction value and growth exposure. Factor strategies don t need to account for an entire universe of stocks; they can be much more selective and include (or exclude) stocks based on rules determined by the strategy s underlying factor definitions and methodology. Therefore, factor-based strategies may be better equipped to exclusively target true value or growth companies. Factor strategies may give investors more control over risk drivers The sector weightings of traditional style indexes tend to influence their risk-return profiles more than the exposure to the value and growth factors themselves. For example, 62% and 49%, respectively, of the return variance (risk) of the value and growth indexes shown in Exhibit 3 EXHIBIT 3: Style indexes often have sector biases that influence their risk profiles, but factor strategies can control for such tilts so that risk is driven predominantly by the desired factors and not unintended exposures, such as sector effects. Analysis of Risk Drivers Factor Exposure & Stock Selection Sector Allocation 4% 7% 38% Value Style Index Growth 49% 51% Style Index Value Factor Momentum Factor 62% 96% 93% Factor strategies shown are sector neutral. Analysis of variance (ANOVA) from 1986 through 2015. Source: FactSet, as of Dec. 31, 2015. 3
were determined by sector exposures. With the factor strategies, only a small fraction of the risk was driven by sector exposures, leaving the rest of the risk profile to be determined by individual stock selection and factor exposures. In other words, factor strategies can control for unintended exposures, such as sector effects, so that the risk-return profiles will be driven predominantly by factors. A factor-based approach may provide better value Factor strategies can provide targeted exposure to value stocks by identifying companies trading at low P/E ratios (for example), and excluding stocks that aren t. Exhibit 4 illustrates that, on average, the stocks within this value factor strategy were cheaper than a commonly cited value style index based on four different measures. This is EXHIBIT 4: A value factor approach can target cheap stocks using a number of value metrics and has outperformed over time. Average Valuation Based on Four Key Metrics, 1986 to 2016 Valuation Multiple 30 25 20 15 10 5 0 P/B P/E EV/EBITDA P/FCF Annualized Return Information Ratio Value Factor 11.04% 0.15 Value Style Index 10.64% 0.05 Broader Market 10.38% N/A Past performance is no guarantee of future results. Information ratio: a measure of risk-adjusted return (excess return divided by tracking error). P/B: Price-tobook ratio; P/E: price-to-earnings ratio; EV/EBITDA: enterprise value-to-earnings before interest, taxes, depreciation, and amortization ratio; P/FCF: price-to-freecash-flow ratio. Source: FactSet, Fidelity Investments, as of Dec. 31, 2016. largely because factor strategies do not need to account for an entire stock universe, and can therefore use a targeted definition of value to capture stocks truly trading at a discount. As a result, the value factor strategy has outperformed both the broader market and the value style index over the long term, and has had stronger riskadjusted returns, as measured by the information ratio. Another important consideration is that there are many different ways to define value. For example, investors may examine earnings, sales, or cash flows to judge whether a stock appears inexpensive. The way an index framework or factor strategy defines value can have implications for performance. A factor-based framework can selectively target value stocks based on one or more of these metrics. A single-factor definition of value may expose investors to greater volatility and larger declines, so an approach using multiple value measures is typically preferred due to its diversification benefits. The value factor strategy shown in the exhibits, for example, seeks to capture stocks with both high book-to-price ratios and earnings yields. Momentum can be an effective tool to capture future earnings growth Momentum investing involves selecting stocks that have recently outperformed, based on the idea that the trend is your friend and that market leaders often continue to outperform. Many make a behavioral argument to explain why momentum investing works. Some believe that investors tend to underreact to improving fundamentals (such as earnings growth) or company trends. However, stocks tend to follow earnings, and it s often not until a stock is outperforming that it catches more investors attention and they pile onto the trade. This dynamic is partly what allows winners to keep winning and momentum investing to work. Momentum strategies can be effective tools for targeting growth-oriented companies because stocks with positive 4
INCORPORATING FACTOR STRATEGIES INTO A STYLE-INVESTING FRAMEWORK momentum often continue to have strong earnings. Exhibit 5 shows the average annual realized earnings growth (over the forward 12 months) for a momentum factor strategy versus both the broader market and a growth style index. The momentum strategy had higher earnings growth, likely because traditional growth style indexes hold some companies that aren t truly growth oriented (they may just be expensive, the opposite of value), while factor strategies tend to be more selective. As a result, the momentum strategy has outperformed the growth style index over time. Combining value and momentum may provide more diversified core exposure and outperformance Passive investors who consider the style framework as part of their investing approach often combine style indexes EXHIBIT 5: Momentum strategies have had stronger earnings growth and outperformed growth style indexes over time. Realized Annual Earnings Growth, 1985 to 2016 Annual Growth 20% 15% 10% 5% 0 17.82% Momentum Factor 10.88% Growth Style Index Annualized Return 9.00% Broader Market Information Ratio Momentum Factor 10.92% 0.10 Growth Style Index 9.75% -0.14 Broader Market 10.38% N/A Past performance is no guarantee of future results. Information ratio: a measure of risk-adjusted return (excess return divided by tracking error). Realized earnings growth: average earnings-per-share growth over the forward 12 months, over time. Source: FactSet, Fidelity Investments, as of Dec. 31, 2016. because they are seeking improved diversification. But combining factor strategies may be a better way to achieve this objective. Recall in Exhibit 2 that when traditional value and growth style indexes are combined, they essentially provide broad-market exposure because together they account for the entire large-cap universe. In other words, owning both a value and a growth style index is similar to owning a large-cap core index (but often at a higher cost), and does not provide additional diversification. Diversification is achieved by combining assets with low or no correlation to one another, which can help investors fare better during changing market environments. The value and growth style indexes had an average historical correlation of -0.98. A negative correlation implies that when one asset outperforms, the other will underperform, so a portfolio that holds both may have more consistent performance. However, the value and growth style indexes are almost perfectly inversely correlated (with a correlation close to -1), which means that the two nearly offset one another. Therefore, when they are combined, the result is simple broad-market exposure and any additional diversification benefits are essentially nullified. However, notice that when the value and momentum factor strategies are put together, the combined portfolio plots within the same core box as the combined style-index approach (Exhibit 6). But the enhanced diversification benefits of combining these two factor strategies may not be readily apparent just by seeing where the portfolio plots within the style box. The value and momentum factor strategies have an average historical correlation of -0.49. They are negatively correlated, but they don t offset one another like the style indexes do, implying that the combined factor portfolio should provide enhanced diversification. 5
Exhibit 7 shows that a 50/50 combination of traditional value and growth style indexes rebalanced every year initially matched the performance and then eventually underperformed the broader market over time (the gradual underperformance is due to rebalancing back to a 50/50 portfolio each month). When value and momentum factor strategies are combined, however, the resulting portfolio has outperformed over the longer term and, due to the improved diversification, also had higher risk-adjusted returns. Investment implications Due to their underlying methodologies and ability to be more selective, factor strategies may provide more targeted value and growth exposure than traditional style indexes. Additionally, when combined, the resulting diversified factor portfolio outperformed the combined style portfolio, which essentially offers simple broadmarket exposure, often at a higher cost. Value and momentum are just two of several factor exposures to consider, as tools to add incremental returns, reduce risk, or achieve a desired investment outcome. Having said that, passive investors who employ a style-investing framework need not discard their current approach to begin incorporating factor strategies into their portfolios. They can use value and momentum factor strategies as building blocks to gain purer value and growth exposure. (Please see the other articles in our series on factor investing for more details.) EXHIBIT 6: The combined factor portfolio, combined style portfolio, and large-cap core index are all considered core. Combined Style and Factor Portfolios within a Style Framework Value + Momentum Factors Large Value Core Growth Large-Cap Core Index Value + Growth Style Indexes EXHIBIT 7: The combined factor portfolio outperformed both the combined style portfolio and the broader market over time. Cumulative Relative Returns 400% 300% 200% 100% 0% -100% Mid Size Dec-85 Dec-87 Dec-89 Dec-91 Dec-93 Dec-95 Dec-97 Dec-99 Dec-01 Dec-03 Dec-05 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Small Style Annualized Return Information Ratio Value + Momemtum Factor 11.07% 0.28 Value + Growth Style Indexes 10.32% -0.14 Broader Market 10.38% N/A Average positioning from 2012 through 2016. Combined portfolios are equally weighted and rebalanced monthly. Large-cap core index: Russell 1000 Index. Source: FactSet, Morningstar, Fidelity Investments, as of Dec. 31, 2016. Past performance is no guarantee of future results. Combined portfolios are equally weighted and rebalanced monthly; assume reinvestment of dividends; and exclude fees, taxes, and other implementation costs. Information ratio: a measure of risk-adjusted return (excess return divided by tracking error). Broader market: Russell 1000 Index. Underperformance of combined style portfolio due to rebalancing. Source: FactSet, Fidelity Investments, as of Dec. 31, 2016. 6
INCORPORATING FACTOR STRATEGIES INTO A STYLE-INVESTING FRAMEWORK Authors Darby Nielson, CFA l Managing Director of Research, Equity and High Income Darby Nielson is managing director of quantitative and technical research for the Equity and High Income division of Fidelity Investments. In this role, he leads a team of analysts conducting quantitative research in alpha generation and portfolio construction for Fidelity s equity and high income funds, along with a team of analysts providing technical research recommendations to the division s portfolio managers. Bobby Barnes l Quantitative Analyst, Equity and High Income Bobby Barnes is a quantitative analyst at Fidelity Investments. In this role, he is responsible for conducting alpha research to generate stock ideas and for advising portfolio managers on portfolio construction techniques to manage risk. Matthew Horne, CFA l Director, Sector and ETF Investment Strategy Matt Horne is a director of sector and ETF investment strategy at Fidelity SelectCo, a division of Fidelity Investments. He is responsible for supporting the distribution efforts for sector products and ETFs, working with internal and external partners to educate clients on sectors and ETFs and increase product visibility. Fidelity Thought Leadership Director Christie Myers provided editorial direction for this article. 7
1 Market-capitalization weighted. 2 In this article, traditional style indexes denote investable solutions that closely track these indexes. Both the style and factor indexes shown in the exhibits are intended as proxies for investable solutions. Unless otherwise disclosed to you, any investment or management recommendation in this document is not meant to be impartial investment advice or advice in a fiduciary capacity, is intended to be educational and is not tailored to the investment needs of any specific individual. Fidelity and its representatives may have a financial interest in any investment alternatives or transactions described in this document. Fidelity receives compensation from Fidelity funds and products, certain third-party funds and products, and certain investment services. The compensation that is received, either directly or indirectly, by Fidelity may vary based on such funds, products and services, which can create a conflict of interest for Fidelity and its representatives. Fiduciaries are solely responsible for exercising independent judgment in evaluating any transaction(s) and are assumed to be capable of evaluating investment risks independently, both in general and with regard to particular transactions and investment strategies. Information presented herein is for discussion and illustrative purposes only and is not a recommendation or an offer or solicitation to buy or sell any securities. Views expressed are as of the date indicated, based on the information available at that time, and may change based on market and other conditions. Unless otherwise noted, the opinions provided are those of the author and not necessarily those of Fidelity Investments or its affiliates. Fidelity does not assume any duty to update any of the information. Investment decisions should be based on an individual s own goals, time horizon, and tolerance for risk. Nothing in this content should be considered to be legal or tax advice and you are encouraged to consult your own lawyer, accountant, or other advisor before making any financial decision. Stock markets, especially non-u.s. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Investing involves risk, including risk of loss. Past performance is no guarantee of future results. Diversification and asset allocation do not ensure a profit or guarantee against loss. All indexes are unmanaged. You cannot invest directly in an index. Index definitions Russell 1000 Index is a market capitalization-weighted index designed to measure the performance of the large-cap segment of the U.S. equity market. Russell 1000 Value Index is a market capitalization-weighted index designed to measure the performance of the large-cap value segment of the U.S. equity market. It includes those Russell 1000 Index companies with lower price-to-book ratios and lower forecasted growth rates. Russell 1000 Growth Index is a market capitalization-weighted index designed to measure the performance of the large-cap growth segment of the U.S. equity market. It includes those Russell 1000 Index companies with higher price-to-book ratios and higher forecasted growth rates. Russell and Russell 1000 are registered trademarks of the Frank Russell Company. Third-party marks are the property of their respective owners; all other marks are the property of FMR LLC. If receiving this piece through your relationship with Fidelity Institutional Asset Management SM (FIAM), this publication may be provided by Fidelity Investments Institutional Services Company, Inc., Fidelity Institutional Asset Management Trust Company, or FIAM LLC, depending on your relationship. If receiving this piece through your relationship with Fidelity Personal & Workplace Investing (PWI) or Fidelity Family Office Services (FFOS), this publication is provided through Fidelity Brokerage Services LLC, Member NYSE, SIPC. If receiving this piece through your relationship with Fidelity Clearing & Custody Solutions or Fidelity Capital Markets, this publication is for institutional investor or investment professional use only. Clearing, custody, or other brokerage services are provided through National Financial Services LLC or Fidelity Brokerage Services LLC, Members NYSE, SIPC. 2017 FMR LLC. All rights reserved. 788123.3.0