This is the third and final part of a three part series on Factor Investing.  See also part 1 and part 2.

We have introduced the concept of Factor Investing (or Strategic Beta).  In this article, I will wrap up the series with a discussion on three topics:  1) what are my ‘favorite’ factors,  2) what are the risks associated with using a strategic beta fund, and 3) how can we use strategic beta funds in an investment portfolio?

My Favorite Factors

For this article, I will focus my comments on stock factors.  My top four factors are momentum, gross profitability, free cash flow yield, and the combination factor of gross profitability-cash flow yield.

The reasons I weight these factors most favorably include:  1) a solid basis in theory for why the factor explains risk-adjusted returns, 2) academic research and Brightwood Ventures research that demonstrates historical alpha, and 3) diversification benefit to a market capitalization weighted portfolio.

Momentum.   In part 2 I discussed momentum in detail.  Momentum has a strong behavior basis.  In addition, Novy-Marx argues that momentum is really a reflection of strong company fundamentals.  I have tested a range of momentum strategies.  More recently, I have added acceleration as a factor.  Research from Xiong and Ibbotson (2015) demonstrated that stocks with the greatest acceleration in price subsequently perform poorly.   My own research shows that combining momentum and acceleration together has significant explanatory power for future stock returns.  I hope to write more on this topic in the future.

Quality.  Gross profitability defined by Novy-Marx (2013) is gross profits-to-assets.  Financial theory implies higher profits should lead to higher returns.  Novy-Marx showed that gross profitability does a better job of explaining future returns than other quality measures.  He argues that gross profitability is a better way to estimate future profitability.  Alpha for Novy-Marx quality in 3-Factor Fama French regression was 3.8% annually.

Cash Flow Yield (CFY).  I have studied a number of ‘valuation’ factors such as Fama and French HML (high book-value minus low book value).  Gregory, Harris and Michou (2003) found that price-to-cash flow as a value factor generated excess risk adjusted returns.  Based on simulations using the Russell 1000 stocks, I find cash flow yield has some explanatory power.  I use a definition for cash flow yield as operating cash flow.

Combining Gross Profitability with Cash Flow Yield.  Novy-Marx (2014) showed that combining the value factor HML with quality produced better returns than just quality alone.  This profitable value combination generated 7.4% excess return for the 500 largest US stocks from 1963 – 2011, compared with 3.2% using quality alone.  Using the definition of cash flow yield above, I combined cash flow yield and gross profitability in a similar manner to Novy-Marx and found similar, if not better, results when applied to the Russell 1000 stocks.  The key point is that combining a value factor such as HML or CFY to highly profitable companies helps to ensure that you are not overpaying for value.

What are the Risks with Strategic Beta Funds

Let’s turn our attention to real investing.  Many companies are implementing factor investment strategies.  Mutual fund companies such as Dimensional Fund Advisors and AQR have focused on these factors.  Blackrock, the largest investment firm in the world, has seen substantial growth in their ETF products based on factor strategies or Strategic Beta.  Brightwood Ventures uses both mutual funds and exchange traded funds that are categorized as Strategic Beta by Morningstar.

These Strategic Beta funds have a number of risks.  They are not assured of beating the market index, especially over short periods of time.  For example, value Strategic Beta funds have underperformed the market for years.  These factor returns are time varying.  Also, it appears that the price investors are willing to pay for these funds have gone up.  It is possible that these factors may not produce results in the future.  Prudence is required.  We should not be willing to buy a factor fund at any cost.

There are implementation risks also.  Academic research sometimes excludes trading costs and slippage.  While the simulation of the factor may show results, a fund manager may fail to generate the same returns because they lose each time they trade based on trading costs or they buy or sell at a price that is different from the price set by the models.

Also, as I speak with investors there is a common misconception that the funds should beat the market index.  The true supposition is that the return will generate better ‘risk adjusted’ returns.  For example, in the case of quality, the funds that implement quality may generate lower returns and lower risk than the market itself.  It may lose on a return basis to the market, but beat the market after risk is accounted for.  Also, as noted above, the timing of the factor returns is variable.  Studies show that value factor tends to drop before and more severely than the market in a crisis and over long periods value excels (somewhat the opposite of quality).  Understanding how these factors respond to market conditions is critical to building a portfolio using them.  This brings us to the final question.

How can Strategic Beta Funds be Used in an Investment Portfolio

Given the strong theoretical basis and historical returns, I believe there is a compelling case for prudent use of strategic beta funds in an investment portfolio.  In particular, I find the idea of combining value and quality together very compelling.  The value and quality factors are non-correlated, providing a diversification benefit.  Many of the factors that have been tested in the academic world are now available in low cost funds.  These funds typically have below average fees compared to all funds.  The fees are higher than the pure index funds, but if fees are held below .5% I believe the potential benefits could be realized.

Based on the discussion above, most all of the single factors noted in part 2 can be found in strategic beta funds.  For example, Brightwood Ventures model portfolios currently hold iShares Quality Factor ETF (QUAL) and we also have mid-cap value ETF (VOE).  In addition, we are using low beta factor funds for international investing such as the iShares low-volatility emerging markets fund (EEMV).

Tactical allocation refers to shifting allocations over time based on conviction.  Brightwood Ventures uses tactical allocation strategies.   As an example of how this can work with factor investing, earlier I noted that quality tends to hold up better when markets crash.  Over the long term, holding quality as a core holding has merit.  Additionally, increasing weight to quality when market valuations are high to mitigate losses in the event of a market downturn is an example of tactical allocation using strategic beta.