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3 Things You Should Know About Factor Investing

Factors are broad, persistent drivers of returns that have been proven to add value to portfolios over decades, according to research data from Dartmouth College . Factor strategies like smart beta capitalize on today’s advancements in data and technology to give all investors access to time-tested investment ideas, once only accessible to large institutions. As factor strategies continue to gather attention, some misconceptions have arisen. I am highlighting – and clearing up – a few here today. 1. Factor strategies are stocks-only. False. Equity smart beta strategies like momentum, value, quality and minimum volatility are by far the most adopted factor strategies and often serve as the gateway to this type of investing. But it’s important to note that the concept extends beyond equities to other asset classes, such as bonds, commodities and currencies. As an example, fixed-income factors are less well known, but similarly aim to capitalize on market inefficiencies. Bond markets are largely driven by exposures to two macroeconomic risk factors: interest rate risk and credit risk. One way that bond factor strategies try to improve returns is by balancing those risks. As investors look for more precise and sophisticated ways to meet their investment goals, we believe we will see more factor strategies in other asset classes, as well as in long/short and multi-asset formats. 2. Factor investing is unnecessary, because my portfolio of stocks, bonds, commodities, hedge funds and real estate is well diversified. Maybe, maybe not. Oftentimes, a portfolio is not as diversified as you might think. You may hold many different types of securities, sure, but those securities can be affected by the same risks. For example, growth risk figures prominently in public and private equities, high yield debt, some hedge funds and real estate. So, as economic growth slows, a portfolio overly exposed to that particular factor will see its overall portfolio return lowering as a result, regardless of how diverse its holdings are across assets or regions. Factor analysis can help investors look through asset class labels and understand underlying risk drivers. That way, you can truly diversify in seeking to improve the consistency of returns over time. 3. Factor investing is a passive investment strategy. Not really. At least we don’t look at it that way. Factor investing combines characteristics of both passive and active investing, and allows investors to retain many benefits of passive strategies, while seeking improved returns or reduced risk. So to us, factor investing is both passive and active. While we think traditional passive, traditional active and factor strategies all have a place in a portfolio, it is not news that some of what active managers have delivered in the past can be found through lower-cost smart beta strategies. This post originally appeared on the BlackRock Blog.

Difference Between Value Stocks And Growth Stocks

Analysts like to separate stocks into two categories: value and growth. What is the difference between value stocks and growth stocks, and which style provides better returns? There is no exact definition explaining the difference between value stocks and growth stocks, but each has its own distinct characteristics. In general, value stocks have low price ratios and growth stocks have high price ratios. Value stocks as a whole have been shown to outperform growth stocks over time. Future Expectations The low price ratios of value stocks are a result of investors being cautious about the future of the underlying companies. Similarly, the high price ratios of growth stocks are a result of investors being excited about the future of the underlying companies. While discussing mutual fund investing using either growth or value stocks, Fidelity says the following : Growth funds focus on companies that managers believe will experience faster than average growth as measured by revenues, earnings, or cash flow. The goal of value funds is to find proverbial diamonds in the rough; that is, companies whose stock prices don’t necessarily reflect their fundamental worth. In the stock market, companies are valued based on future expectations. Wonderful vs. Weak If a company’s growth begins to slow down or its profits start to decrease, the result will be a lower share price. Value stocks are typically companies with recently poor operating results and negative outlooks. The weak performance could be due to macroeconomic events or company specific challenges. It could be a temporary setback or a major loss of market share. If a company is growing and its profits are increasing rapidly, the result will be a higher share price. Growth stocks are typically companies with recently phenomenal operating results and bright futures. The wonderful performance could be due to a rising tide in a particular industry or great management of a specific company. If growth stocks are “wonderful” and value stocks are “weak”, how can value stocks be better investments than growth stocks? Value Premium It turns out that human nature causes value stocks to provide better long-term returns than growth stocks. People get too excited about growth stocks and too afraid of value stocks. While discussing the recent trend of investors moving away from value opportunities, Morningstar’s Ben Johnson said : What we’ve seen historically is that it’s exactly this sort of capitulation, this sort of behavioral function that may actually lead to the existence, the creation, the persistence of the value premium. Value exists because there are suckers on the other side of the poker table willing to take the flipside of the value bet. They are betting on growth or something else. Real, true, strong hands at that poker table, in all likelihood will continue for many years to come, to reap the benefits of that value bet, assuming that they are strong hands. The optimism towards growth stocks makes them overvalued. The pessimism toward value stocks makes them undervalued. Investors become overly confident about a growth stock’s future and overly scared about a value stock’s future. Herd Behavior Through a phenomenon called herd behavior, human nature causes a gap to occur between the value of a stock and its price. Herd behavior says that “individuals in a group will act collectively without centralized direction.” In Thomas Howard’s book, Behavioral Portfolio Management , he talks about how following the crowd is an evolutionary trait. It was beneficial at one point but now does more harm than good, especially in investing. Howard says: Doing the same thing as everybody else, the definition of social validation, also made sense thousands of years ago when life was full of danger. Since we lived in small groups then, we depended on others to sense danger and react instinctively. You didn’t want to be the slowest member of the group when fleeing the tiger. In contrast, today we frequently want to take positions different from the emotional crowd as a way to harness the price distortions resulting from collective behavior. Because the stock market is nothing more than a group of individual investors, herd behavior is a common occurrence. No investor wants to be left behind. As prices start climbing, everyone wants to jump on board. This results in the high valuations of most growth stocks. Once prices start falling, investors dump the underperforming stocks in mass. This results in the low valuations of value stocks. It’s important to refrain from following the crowd and to avoid investing in overvalued stocks rather than undervalued stocks. The Difference Between Value Stocks and Growth Stocks A summary of the difference between value stocks and growth stocks is: Value stocks are undervalued, out-of-favor companies with recently poor operating performance and slowing growth. Investors overreact to these stocks and value them lower than they should be. Growth stocks are overvalued, “hot” companies with recently great operating performance and rapid growth. Investors overreact to these stocks and value them higher than they should be. Understanding the difference between value stocks and growth stocks will allow investors to profit greatly over time.

Declining Housing Starts Equals Big Profits

Since peaking at 2,111 on April 20, 2016, the S&P 500 has rolled over. The broad market index now sits at 2,050 – nearly 3% lower in just a couple of weeks. The S&P 500 chart below has a distinctly negative look to it. Click to enlarge As the S&P 500 peaked, the moving average convergence divergence (MACD) momentum indicator showed significant negative divergence. This is a strong warning sign that the current rally is exhibiting exhaustion and could be vulnerable to a reversal. The S&P is well-below its 9-day exponential moving average (EMA) of 2,068, which means the market could test its 50-day moving average at 2,035. But given recent negative readings on a host of economic reports here and around the globe, there’s a real possibility that a much deeper move is in the cards. And should the market pass through the 2,035 level, there is no real support until roughly 1,980. That’s another 3.4% from current levels. For this reason, traders should use any strength in the market to unload long positions, while also adding short positions. One possible short position is the S&P Homebuilders Fund (NYSE: XHB ) You see, the homebuilding sector is vulnerable here to a sharp pullback. Below is a chart of XHB… Click to enlarge This chart looks eerily similar to the S&P 500 chart. It shows that XHB has also fallen below its 9-day EMA, while also sitting at its 50-day moving average. This means the $34 level effectively becomes XHB’s new level of resistance. This provides an excellent opportunity to short XHB. With the close proximity to the new resistance level at $34, we can quickly exit the position if resistance with a small loss if resistance breaks. On the other hand, if the nine-day resistance holds, XHB should fall to one of the lower support lines at about $31.20 or as low as $30.20. Now, we hold that the $30.20 price target best aligns with our expectation of a moderate pullback (~3.4%) in the S&P 500. This make $30.20 a reasonable target over the next few weeks. XHB closed at $33.29 today. Now, by taking a short position at this level, we’re risking $0.54 per share if the stock moves higher. Conversely, we stand to pocket $3.00 per share if we’re right and XHB moves lower. That gives us a good risk/reward setup. But we can mitigate our risk even further by purchasing put options on XHB instead of shorting the stock. Here’s how… Let’s assume you’d typically short 500 shares of a recommended stock. At today’s price of $33.29, you’d pony up about $16,650 to short the shares. Now, most investors are willing to absorb a 10% drawdown on shorted stocks should the stock run the wrong direction. This would limit your loss to $1,665 before you exited the position. But, because $1,665 is the most you’re willing to risk, you could instead use the $1,650 to buy the puts. But let’s reduce our risk even further by cutting our maximum loss in half… The XHB June $34 puts closed Thursday at $1.15. With $825, you can purchase seven put options on XHB. Since each option contract covers 100 shares, that gives you control of 700 shares of XHB – versus the 500 shares you would have shorted with the $16,665. You’ve reduced the risk on this trade, while also increasing the potential reward by controlling more shares. This is the right way to speculate with puts. Of course, if we’re wrong on this trade, you could lose 100% of the money you used to buy the puts. But it’s far better to lose 100% of $825 than to lose 10% of $16,665. And if we’re right on this trade, you can make more money by owning seven puts than by shorting 500 shares. So, by purchasing puts instead of shorting the shares, we reduce our risk and increase our potential reward. It makes for a more intelligent trade for managing risk/reward. Here’s the trade in a nutshell… Buy the XHB June $34 put options (XHB160610P0003400) up to $1.25. This option closed yesterday at $1.15 when XHB closed around $33.29 per share. You should be able to get into this trade as long as XHB is trading above $33.30 per share by the time you enter your order. If the stock falls and the option moves out of range, or if the option spikes higher as a result of this recommendation, give the trade a day or two to come back into range. Going forward, if XHB falls to our downside target at $30.20 per share, the June $34 puts will be worth at least $3. That’s a 161% gain on the trade. Once the options have double in price, sell half the position. This will eliminate any chance of a losing trade. Then focus on maximizing profits if XHB moves lower. One caveat…. It’s important to remember this is a speculative trade. We’re buying short-term options in anticipation of a stock market pullback. There’s no guarantee the market will fall or that XHB will decline even if the broader market falls. You can lose everything you put into this trade. So, please, limit your risk to less than half of what you would normally be willing to lose on the stock. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.