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The Free Lunch Of Factor Investing

Factor investing is a hot topic among the folks in the business of designing better investment mousetraps. So rather than focus on individual stock picking, this approach recommends that you invest in an index that’s weighted towards all specific characteristics (“factors”) shared by groups of stocks that make them more likely to beat the market. These include factors such as momentum and value. By doing so, factor investing combines the low costs and simplicity of indexing with the additional possibility of “beating the market.” Researchers have looked at dozens of factors that appear to outperform the mainstream, broader market-weighted indexes. A handful have proven to be meaningful. These findings have also been responsible for the launch of dozens of factor-based exchange-traded funds (ETFs) in the last five years or so. Value Value investing has a long and storied tradition in investing, going back to the legendary Ben Graham. As outlined in his classic work, ” Security Analysis ,” measures such as the price-to-book ratio (the firm’s share price divided by the value of its assets minus its liabilities) and the price-earnings ratio are the most basic ways for measuring value. Stocks with low valuations have tended to beat those with high valuations over time. In the United States, the cheapest 30% of large- and mid-cap stocks (based on price/book) have outpaced the most expensive 30% by approximately 2.5% annualized from 1927 through May 2015, according to data cited by Morningstar. From its inception in March 2006 through May 2015, the Guggenheim S&P 500 Pure Value ETF (NYSEARCA: RPV ) outpaced the market-cap-weighted S&P 500 Value Index, which tracks the cheaper half of the S&P 500, by 2.8% each year. Morningstar ranks it as a five-star fund. It is down 7.79% year to date. Size The small-cap effect – the tendency for smaller stocks to outperform large-cap stocks – is also a well-known tenet of modern finance. As such, it has been studied by academics and practitioners alike for decades. The higher performance of small caps comes at the cost of higher volatility. Overall superior performance may be due to exceptional returns from a few outliers rather than from smaller companies as a whole. And small caps can underperform broader markets for years at a time. But if you’re looking for better performance over the long term, small-cap stocks are the way to go. Invest in small caps by, say, ranking them by revenues, and you have the basis for some impressive outperformance. The RevenueShares Small Cap ETF (NYSEARCA: RWJ ) is comprised of the same securities as the S&P Small Cap 600 but weights the stocks according to top-line revenue instead of market capitalization. Morningstar ranks it a four-star fund. It is down 4.80% year to date. Momentum Momentum investing is a dirty word for fundamental investors schooled in Ben Graham’s number-crunching culture of fundamental analysis. Somehow it reeks of short-termism and superficiality of technical analysis. It also seems to question the validity of the efficient market hypothesis. That may well be true. But in the short run, recent performance tends to persist. Winners over the past six to 12 months tend to continue to outperform over the course of the next several months while those that have underperformed often continue to lag. And the momentum effect hasn’t gone away even though it was first published in academic literature in 1993. Momentum’s outperformance in 2015 is particularly impressive. The iShares MSCI USA Momentum Factor Index ETF (NYSEARCA: MTUM ) tracks the MSCI USA Momentum Index and consists of stocks exhibiting relatively higher momentum characteristics than the traditional market-capitalization-weighted parent index, the MSCI USA Index. It is up 5.61% year to date. Low volatility Perhaps the most puzzling among the major factors behind outperformance is the claim that stocks with less volatile share prices seem to deliver higher long-term returns than more volatile ones. This flies in the face of both accepted finance theory and common sense – that more volatile (risky) stocks should deliver higher returns. Still, analysts and academics have confirmed that the effect is real and applies in markets around the world. This has yet to be confirmed in practice, however, as low-volatility ETFs in the U.S. market have yet to exhibit much of any kind of outperformance versus the S&P 500. The iShares MSCI USA Minimum Volatility ETF (NYSEARCA: USMV ) seeks the investment results of an index composed of U.S. equities that, in the aggregate, have lower volatility characteristics relative to the broader U.S. equity market. It is up 2.79% year to date. Quality Perhaps the least surprising of these factors is that “high-quality” stocks seem to do better than lower-quality ones. Quality is measured by factors such as low levels of debt, stability of earnings and high returns on equity. Strong competitive advantages make these firms slightly less sensitive to the business cycle than lower-quality firms. In a recent study, “Quality Minus Junk,” Cliff Asness of AQR found that stocks with high and growing profitability, high payout rates and low market volatility and fundamental risk historically outperformed their less-advantaged counterparts. High-quality stocks have, indeed, outperformed the S&P 500 over the past five years, if only slightly. And it may be even more surprising that they have outperformed the ultimate high-quality stock investors’ vehicle, Berkshire Hathaway (NYSE: BRK.B ) (NYSE: BRK.A ), by close to 2 to 1. The iShares MSCI USA Quality Factor ETF (NYSEARCA: QUAL ) seeks to track the investment results of the MSCI USA Sector Neutral Quality Index composed of U.S. large- and mid-capitalization stocks with quality characteristics as identified through certain fundamental metrics. It is up 2.22% year to date. Thanks to the vagaries of the markets, not all of these strategies will outperform each and every year. As a group, some strategies may underperform for years. But studies suggest that in the long run, stocks with these five factors have comfortably and consistently beaten the broader market and in different stock markets around the world. So what’s the secret behind the success of factor investing? On the one hand, higher returns may come from taking on higher risk. Studies have shown that value, momentum and size have all beaten the standard MSCI World index, but at the cost of taking on slightly more risk. Indeed, that’s also where you see the biggest outperformance. But with other factors, that explanation doesn’t hold. Quality has delivered outstanding returns at lower volatility than the wider market. Quality companies are intuitively less risky: they are more likely to survive economic downturns. The same applies to low-volatility stocks. So lower risk should yield lower returns. The secret may lie in the world of behavioral finance and Mr. Market’s mood swings. Investors may prefer the excitement of a new and novel story. That’s why they undervalue both quality companies and low-volatility stocks. They just seem dull. Whatever the reason, factor investing today offers investors a reasonable chance to earn market-beating returns with little effort. But free lunches in investing don’t last, especially as such simple strategies keep on winning. Excess returns eventually will vanish. Investors will drive up the valuations of these stocks to the point where they can no longer outperform. But for now, the size of factor funds makes them too small to matter. Until then, enjoy your free lunch.

3 Ways To Play A Nearing Fed Rate Hike

Summary Thanks to weaker than expected job growth and retail sales along with global economic uncertainty, the futures market is not expecting a rate hike until into 2016. Investors want to plan for rising interest rates should look for investments with low duration, low interest rate sensitivity or that can profit from higher rates. In this article, I suggest three different ETFs that can fit those criteria. With the target Fed Funds rate sitting at 0% for the last 6+ years, the Fed is finally getting poised to raise interest rates again. Many watchers felt a rate hike in 2015 was imminent until a slew of economic data – weak job growth and retail sales data along with uncertainty in China – have pushed off rate hike expectations into 2016. Fed funds futures suggest that there’s only a 50-50 chance will see a rate hike at the March Fed meeting with the first likely hike coming in June. For those looking to protect themselves from rising rates, now might be a good time to reposition your portfolio. That means looking for investments that maintain a low duration, staying away from sectors that are highly rate sensitive and looking for stocks that can profit from higher rates. If you’re looking to stay away from interest rate risk, consider these ETFs for your portfolio. The iShares 1-3 Year Treasury Bond ETF (NYSEARCA: SHY ) This is the good old fashioned conservative approach. Its 30 yield of 0.49% won’t necessarily impress income seeking investors but with a beta of near zero this is exactly the type of risk averse investment that those looking for safety should consider. Since its inception in 2002, we’ve been able to see how the fund performs in both a rising rate and falling rate environment. In the 2004-2007 period when the Fed Funds rate rose from 1% to over 5%, the fund managed a total return of around 8%. Not a huge return by any means but it demonstrates how the fund was still able to generate a return even in a rapidly rising rate environment. In the subsequent 2007-2008 period during the financial crisis when the target Fed Funds rate dropped to 0%, the fund returned around 12%. These are solid returns in both scenarios but the risk minimization and capital preservation strategy of this ETF is what matters most. The SPDR S&P Bank ETF (NYSEARCA: KBE ) Banks profit when the yield curve is steeper and interest rates are higher. This fund debuted right at the tail end of when interest rates were rising in 2005. As you can see, the overall performance of the fund followed the Fed Funds rate downward. KBE Total Return Price data by YCharts Conversely, it would be expected that bank stocks should outperform when rates begin moving back up. Being an equity ETF, this will still experience the volatility that comes with investing in the stock market but it should be positioned better than the broader market when rates finally begin to move back up. The PowerShares S&P 500 ex-Rate Sensitive Low Volatility Portfolio (NYSEARCA: XRLV ) Debuting just earlier this year, this ETF looks to isolate the stocks of the S&P 500 that exhibit the lowest volatility and low interest rate sensitivity characteristics of the broader index. The fund’s composition is largely as one would expect. Most of the fund’s assets are invested in financials, industrials, consumer defensive and health care stocks – areas of the market that experience steady demand and are less prone to economic fluctuations. There’s not much of a track record to go on with this ETF but the strategy is such that it should help limit the downside associated with interest rate risk while maintaining broader exposure to the equity markets.

How Knowledge Investments Translate Into Superior Profitability

Companies that invest in more knowledge assets, or intangible assets, than their peers leads to a sustainable competitive advantage that manifests itself in superior margins and profitability. Overall, Knowledge Leaders spend about 4x more on intangible investments than Knowledge Follower. The unique capital stock created by knowledge investments enables Knowledge Leaders to command higher margins, keep a more flexible balance sheet, and derive greater profitability than their less knowledge-intensive peers. Regular readers are by now well versed in our belief that companies that invest in more knowledge assets, or intangible assets, than their peers leads to a sustainable competitive advantage that manifests itself in superior margins and profitability. We call these knowledge intensive companies Knowledge Leaders. One of the most important takeaways of the academic literature on knowledge investments is that research shows that knowledge intensive companies end up having higher “future market share, future sales growth and future return on assets” than their less knowledge intensive peers ( Lev, 2005 ). In today’s post, we thought we would illustrate to our readers the statistical differences between Knowledge Leaders and Knowledge Followers. As always, the data we are using Gavekal Capital’s proprietary intangibly-adjusted, USD-based data and we are looking at all mid and large cap companies in the developed world. However, before diving in let me provide a brief overview of how the selection process begins in defining a knowledge leader. The first step of our process is to intangibly-adjust the financial statements of about 3000 companies (2000 in the developed world, 1000 in the emerging markets), going back to 1980 where possible, by removing R&D and a portion of SG&A expense and placing it on the balance sheet as a long-term asset. We carry this new long-term asset, called intellectual property, at historic cost by depreciating the asset and allow the depreciation charge to flow through the statement of cash flows and income statement. The goal here is simply to adhere to the symmetry accounting rule by treating intangible investments as similarly as tangible investments as possible. Once we have an intangible-adjusted set of financial statements, we run the companies through a quantitative screen that looks at seven different variables categorized by: knowledge intensity, financial strength, and profitability. In order for a company to be considered a Knowledge Leader, it must pass the following thresholds: Companies must spend at least 5% of sales on knowledge investments or have at least 5% of assets represented by knowledge. Companies must generate over 20% gross margins. Companies must have less than 3x gross financial leverage. Companies must have less than 50% net debt as a percent of total capital. Companies must have a positive trailing seven year average return on invested capital. Companies must have at least 10% operating cash flow margin on average over the last seven years. Companies must have a positive trailing seven year average free cash flow. For further explanation, please read our three part series on the academic foundation and the real-time application of the Knowledge Effect. Now that we have our foundation in place, let’s begin with the most basic assumption that Knowledge Leaders invest more in intangible assets than Knowledge Followers. Investments in intangible assets fall into two broad categories: research and development (R&D) and firm specific resources. Firm specific resources is a catch-all for other intangible investments such as advertising, brand building, employee training, and codified information. The median Knowledge Leader invests 2.7% of its sales in R&D compared to the median Knowledge Follower which invests just 0.06% of its sales in R&D. The median Knowledge Leader invests 6.9% of its sales in firm specific resources compared to the median Knowledge Follower which invests 2.3% of its sales in firm specific resources. Overall, Knowledge Leaders spend about 4x more on intangible investments than Knowledge Followers. This leads to the median Knowledge Leader having over 7x more intellectual property assets on its balance sheet than the median Knowledge Follower. The median Knowledge Leader has over 15% of its assets in long-term intellectual property. Because investing in knowledge investments creates a unique capital stock, Knowledge Leaders are able command greater profit margins. For those that are familiar with Warren Buffet’s “moat’ concept, a unique capital stock helps to create the moat for a company to maintain its competitive advantages. The median Knowledge Leader has a gross margin of 41.6% while the median Knowledge Follower has a gross margin of just 24.2%. Knowledge Leaders have higher gross margins in nine out of ten sectors. (click to enlarge) Under the archaic accounting rule SFAS #2, knowledge investments must be immediately expensed in the period they occur. This creates a massive distortion on company financial statements as investors have limited information on the innovative activities corporations are undertaking. Because this conservative accounting rule is in place, conservative institutions like banks will not loan money for knowledge investments since there isn’t any physical capital attached to the investment. This leads to a situation where knowledge investments are almost always entirely equity finance and consequently, the balance sheet of Knowledge Leaders is much more liquid and less levered than Knowledge Followers. Knowledge leaders have more cash and less debt as a % of total capital than Knowledge Followers. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) The good news is that Knowledge Leaders are not sacrificing return by having a more liquid, less levered balance sheet either. In fact, the median Knowledge Leader has superior return on assets (ROA), return on equity (ROE) and return on invested capital (NASDAQ: ROIC ). If we break out Knowledge Leaders by sector its very apparent that this profitability superiority is wide and broad based. (click to enlarge) (click to enlarge) (click to enlarge) (click to enlarge) All in all, the unique capital stock created by knowledge investments enables Knowledge Leaders to command higher margins, keep a more flexible balance sheet, and derive greater profitability than their less knowledge intensive peers. The original posting of this article can be found here . All data was created by the author and sourced from Gavekal Capital and FactSet.