Factor-Based: An Alternative to Market Cap Weights


Factor-based investing, also known as evidence-based investing, builds on academic research and allows for an alternative to market capitalization weighting. Capitalization weighted portfolios by their very nature have short comings. They systematically invest more in stocks when they are overpriced and too little in stocks when they are underpriced. They can also lead to heavy sector concentrations. This phenomenon likely increases portfolio volatility. Increased concentrations in larger stocks and specific sectors, can lead to periods of overly strong performance, which can draw investors off the sidelines and overly weak performance, which may scare investors away from staying invested. Click here to read the entire Research Paper.

Factor-based investment models have existed for decades. Well known investors and academics such as Dr. Harry Markowitz, Willian Sharpe, Eugene Fama, Kenneth French, Benhamin Graham and David Dodd1 all utilized fundamental valuation techniques to evaluate stock movements based on underlying factors such as size or value. Many of these notable bodies of work have been added to by the research of Robert Haugen, Zhiwu Chen, Mark Carhart, Richard Roll and Stephen Ross2,3,4 who focused their efforts on the use of multiple factors.

As building portfolios has evolved so have advancements in technology. Custodial platforms continue to enhance their systems both in what data they make available, and the ability to trade and track large numbers of positions across multiple portfolios at the same time. It is also worth noting that trading costs have drastically declined. This makes transacting in a larger quantity of positions, far more cost effective than ever before.

In this paper, we will discuss how factor-based investing can be an alternative to market capitalization weighting, when building a diversified portfolio. We will discuss various factor categories. We will review WealthFactor’s factor-based methodology for building equal security and sector weighted portfolios, based on its long-term view of investing and its approach to rebalancing.

Research Paper – Factors: An alternative to Market Cap Weighting

Leveraging Academic Research and Technology

Stock pickers have tried to outperform the market for as long as there has been a market. Initial academic modeling was largely based on the idea that markets are efficiently priced. Tecent research by, Chen, Carhart, Roll and Ross2,3 has provided a more realistic framework, and has also broadened the universe of factors that drive markets, to include quantitative factors such as volatility, size, value, quality and momentum.

The use of passive investing techniques has been on a steady increase, largely driven by the impact of fees, and an investor’s perception that if they aren’t always outperforming the market then any additional fees aren’t deserved. The use of passive

investing techniques started with traditional market capitalization weighted solutions. In recent years there has been a steady increase of solutions that utilize factor-based investing methodologies as an alternative. These portfolios are often constructed in a rules-based format.

The popularity of passive investment management based on market capitalization weighted portfolios may be setting many investors up for a sub-optimal experience. In addition to being forced to invest in bigger more liquid companies, large asset managers have inherent issues in overweighting companies and sectors that did well previously. While this can be good when times are good, it can turn quickly when markets are declining.

A factor-based portfolio can potentially assist an investor in avoiding unintended concentrations or exposures, such as those mentioned above. Both computing power and access to data have come a long way making it possible to evaluate thousands of individual securities based on things like their price-per-earnings ratio.

Individual Securities

Most investment advisors look at using individual securities as an inefficient way to do business. For

advisors providing cookie-cutter offerings or who rely on dated operating infrastructure this may be true. The potential benefits are worth the efforts needed to transition away from a pooled vehicle centric portfolio. By going directly to the underlying security an investor can take control of their exposure to businesses that negatively impact society, avoid unintended concentrations or exposures, isolate factors that drive long-term returns, eliminate a layer of costs and fees, and enhance the ability to manage for taxes.

Research Paper – Innovation in Wealth Management

WealthFactor’s Factor-Based methodology:

The utilization of data by professionals to build portfolios has a long history. Many major asset managers are turning to building quantitative or systematic methods when managing their portfolios. Often they are trying to predict which specific securities will outperform in the future. The repeatability of a factor-based model designed to be predictive is uncertain. WealthFactor has built its process from the passive investor’s perspective. Utilizing factors as a means to avoid the negative effects of market capitalization weighting, but seeking to avoid forecasting or concentrated bets.

1) Creating the investable universe: WealthFactor’s process starts with two large universes of individual securities. It constructs one universe in the United States and another one that represents the rest of the world. Each universe is divided in half, isolating companies greater than $5 billion in market capitalization and those below.

2) Socially responsible: This process filters out companies that are not taking action to reduce their negative impacts on society. As the world becomes more aware and focused on things like the environment, societal impact and corporate governance (ESG), capital markets will penalize these companies in terms of greater costs of capital. It may also be likely that many of these companies experience declines in their business due to negative press or penalties associated with some of their business practices. Companies that do not meet our socially responsible criteria are filtered out.

3) Factor-Based position identification: A multi-factor, systematic ranking approach is used based on measures of quality, value, size and momentum to identify which securities in each sector will be considered for inclusion in the portfolio.

4) Security, Sector and Geography Weighting: For the Non-US part of the portfolio we conceptually start out with the goal of an equal region weighting. That is then modified by the percentage of investable securities in each region. This process skews the percentage higher in Europe and Asia versus other areas. Next across all groups (size and geography) we seek to equally weight sector exposures. Similar to the regional process this target gets modified for sectors where there are far fewer companies like utilities and basic materials.

Based on these categories and groups we then build a portfolio of 4-500 positions each position within each category or group is equal weighted. The process persistently attempts to avoid specific bets and concentrations, seeking to efficiently capture the returns of broad markets over time.

5) Rebalancing: As markets move so do the exposures and weightings of our portfolio. This can be a healthy phenomenon for a portfolio, as individual securities and sectors have historically exhibited periods of momentum. Rather than try to predict when there is momentum in a stock or sector, we instead utilize a multi-part rebalancing approach. On a more frequent basis we employ a “soft-rebalance”. In this rebalance we allow for increases in position and allocation size. This allows us to participate in the momentum of markets. On a less frequent basis we employ a “hard-rebalance” returning all of the positions and sector weightings back to equal.

6) Risk-management: With hundreds of securities in each portfolio, and our avoidance of individual and sector level concentrations, things like stop-losses would not likely provide a meaningful benefit within this framework. Risks beyond market risk are limited through the systematic implementation of a diversified investment framework designed to avoid concentrations.

Conclusion

WealthFactor’s portfolio management methodology applies a disciplined investment process, developed based on decades of academic and real-world insights patterned after large asset managers. Through an evidence-based approach equal-weighted portfolios of individual securities are constructed then periodically rebalanced. The strategy seeks to provide a holistic, socially responsible portfolio solution that allows for tax management.

Fee Efficient + Tax-Smart + Socially Responsible + Risk-Smart

1. Benjamin Graham & David Dodd, Security Analysis.

Harry M. Markowitz, Portfolio Selection, Efficient Diversification of Investments.

William F. Sharpe, Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk.

Burton Malkiel, A Random Walk Down Wall Street.

Eugene F. Fama, Kenneth R. French, The Cross-Section of Expected Stock Returns, The Journal of Finance.

2. Stephen A. Ross, The Arbitrage Theory of Capital Asset Pricing, Journal of Economic Theory, 13 (3) 341-489.

3. Nai-Fu Chen, Richard Roll, and Stephen A. Ross, Economic Forces and the Stock Market, The Journal of Business, Vol 59, No. 3.

4. Robert A. Haugen, The Inefficient Stock Market. & The Inefficient St

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