Category: Market Research Page 1 of 11

Factor Investing

The stock market is often referred to as a single entity but is made up of many moving parts.  Looking beneath the surface at single and multi-factor indexes can help investors better understand trends that may not be as visible when looking at the major indexes.

Factor investing has been around for many years but has only become more mainstream recently as investors have been given easier access to more specialized investments.  This area has been evolving with the growing popularity of “multi-factor” investments.  First, let’s begin with defining single factor investments and then progress onto more complex multi factor methods.

Single Factor

People tend to gravitate toward organization and categorizing information in order to better understand attributes and possible outcomes.  As an example, consider this analogy between factor investing and cars. Cars with big V-8 engines tend to be fast and powerful while those with small four cylinders tend to be more fuel efficient and less performance oriented.  Such a conclusion may not always be the case but is a tendency.  Engine size is simply one “factor” when assessing an automobile.  Investors do this with stocks too.  The most widely recognized indexes are one factor, or “single factor”.  A single factor may also be characterized by a sector such as a semiconductor index or a gold stock index.

The S&P 500 Index may be diversified but it is simply the 500 largest companies.  This makes size or market capitalization the single factor.  Along the same lines, the Russell 2000 Index is a small-cap index.  In the chart below, there was a clear distinction between the performance of large caps versus small-caps during mid-2018 as small-caps led the way higher.  In 2019, large-cap stocks have been displaying overall leadership.  This illustrates how factors can help explain what has been driving returns, giving a deeper perspective than over generalizing movements in the stock market.  Investment choices have become more easily available to investors that attempt to give exposure to those factors.

Multi-Factor

Multi-factor investments are the natural progression after single factor ones.  Common multi-factors include value and growth.  At first glance, these individually may sound like single factors but to determine value or growth, many factors are combined.  For example, an index provider putting together a value or a growth index may use price-to-earnings ratios, price-to-book, or dividend yield among other criteria.  These are most often well-defined, quantifiable filters to find stocks to be included in the index.

If some of the factors already covered are combined, the stock market can be broken down to an even more granular level often called “style investing”.  Each size, small, mid, and large cap is then further separated into growth or value.  In the chart below large-cap value is being compared to small-cap growth.  During the first three quarters of 2018, value stocks were rather subdued while small-cap growth was rewarded.

Factor investing has adopted very specific characteristics beyond the historically common size or styles.  Categorizing stocks down to attributes can yield an interesting perspective.  Some examples are high and low volatility, value, momentum, and quality.  These tend to be multi-factor as it can take a combination of numerous filters to find stocks with the targeted characteristic.

A momentum factor index or investment may use the performance return of multiple time frames and may be absolute returns, or the stocks return, relative to a benchmark. Some index companies define momentum as positive earnings momentum (growth factor). Quality factor investments may include formulas that filter for companies with low debt, stable earnings growth, and measures of profitability.  The recipe for making a multi-factor index it generally transparent and can be found in documentation released by the indexing company.

Having factor-based investment choices allows investors to be positioned to possibly take advantage of various economic or technical conditions.

  • Quality and lower volatility factors may take on defensive characteristics during times of stress in the markets.
  • Momentum and higher beta factors may take advantage of bull market rallies when higher risk is being rewarded.

Active portfolio managers may use rotation methods, moving between various factor investments as conditions change.  In the chart below, the black lined Relative Strength, displays the performance of the high beta factor to the low volatility factor.  A rising black line conveys leadership by the high beta index and a falling line shows leadership period by the lower volatility index.  Technical analysis methods can be applied to the Relative Strength line in order to better define the trend of leadership and its transitions.

Uncovering the idiosyncrasies of the stock and bond market in order to invest strategically has always been an obsessive compassion of the portfolio management team at Spectrum Financial. The team uses several disciplines and factors when constructing portfolios and making investment decisions for its clients.

A Beginner’s Guide to Buy Low, Sell High

A Beginners Guide to Buy Low, Sell High

 “Buy low, and sell high”, is foundational advice often given to beginning investors in order to avoid losses and lock in gains.  In an attempt to reach that goal, a portfolio manager often draws from the discipline of technical analysis which at its core, focuses on the effects of buying and selling pressures on assets such as stocks, bonds and commodities.  Technical analysis is often contrasted against fundamental analysis which focuses on gauging the financial health of a specific company or industry.  The two can also be blended, introducing an additional discipline, economic analysis.  This post will explore the technical analysis discipline which is diverse.  However, most technical analysis tools can be separated into either trend following or mean reversion categories. 

Understanding how markets move

Markets have two states of movement, either trending up/down or rangebound. A portfolio manager must first use indicators specific to identifying the two states of movement. Think of these technical analysis indicators as tools. Having the right tools for the job plays a significant role in the success of the overall investment process.  Like using a hammer to drive a nail or a shovel to dig a hole versus using the shovel to drive a nail and the hammer to dig a hole.  Once an environment is identified, more specific indicators and methods can be used which may reveal further information about the environment.

Indicators of market movements

Indicators are available to detect various traits of price movement.  If “Point Z” is higher than “Point A”, then an uptrend may be present (though what happened in between could play a role in the investment decision).  Trends may be steady or could be choppy.  Even within a choppy uptrend, it may have various degrees of width in the swings.  Indicators exist that simply define a trend as being positive or negative and tools exist that define the level of volatility within the trend.  Rate of change indicators can identify the percentage movement over a specified time period in order to identify trend.  These indicators also display momentum or if the trend is speeding up or slowing down. Why does all this information matter? The more informed you are as to what is going on with a market environment the better equipped you may be to make risk-adjusted decisions for your portfolio.

Moving Averages

Moving averages (displayed below) are popular ways to identify trends because chart readers can easily see if the asset is above the moving average or below. If the asset is above the moving average the trend can be defined as an “uptrend”.  If the asset is below, it can be labeled as a downtrend.  The number of days used to calculate the moving average can vary in order to detect trends of various time frames such as shorter-term, intermediate or longer-term.

200 day
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Mean Reversion

The “buy low and sell high” concept can also be conveyed through mean reversion methods.  In case that term is new to you, mean reversion simply means the movement is stretched, gone further than it typically does, and may soon snap back.  “Overbought” and “oversold” are common terms associated with mean reversion methods.  If a stock is in a trading range, by definition, it reaches an upper point, or extreme and then goes down toward a mean or average.  It may then overshoot and go to a lower extreme, becoming oversold and then revert back higher.  This process may be repeated numerous times.  Trading ranges may be after an uptrend or downtrend has slowed.  These may lead to a full reversal in overall direction or the trend may eventually resume but at a different slope.  Once a trading range is identified, a portfolio manager must then be able to identify what constitutes the extremes or overbought and oversold zones.  Tools of the trade may include Stochastics, Money Flow Index, and RSI, among others (pictured below).

RSI Money Flow
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Volatility Analysis

Tying the states of trending and trading ranges together may also involve volatility analysis.  If volatility is high enough a trend may be observed and at the same time, upper and lower extremes can too.  These are often referred to as trend channels (see below).  Modest adjustments to exposure are often the goal when trend channels are identified such as the adding of positions around the lower channel line or “profit-taking” near the upper channel line. 

Trend Channel
Created with TradeStation. © TradeStation Technologies, Inc. All rights reserved

Why does this matter?

Many investors take a hands-off approach to investing but that puts hard-earned money at the whims of the changing trends, and some bear market trends can be devastating.  Active portfolio management, by way of technical analysis, often includes implementation of the tools discussed above. These tools detect periods of trending or trading ranges.  Refinements with more specific trading tools and methods within those periods can further increase odds of potential success in navigating the unknown waters yet to be seen. This comprehensive approach to investing is used in Spectrum’s management for its clients.

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Spectrum Financial, Inc 2019