Key takeaways
- Factor investing can help drill through broad sector labels to help investors better understand past performance and expected returns.
- Investors taking factor views may be better able to capture the underlying exposure they seek and obtain complementary views compared to traditional sector labels.
- It’s not factors vs. sectors. It’s factors and sectors.
This article has a related client version.
Sector classifications are useful for viewing companies in similar lines of business, but companies often have business lines that span multiple industries or sectors. For example, Amazon is one of the leading “FAANG” technology companies. It sells goods online, offers e-commerce services, streams music and video, produces media content, operates a cloud platform, has AI capabilities, sells consumer products like Kindle, Fire, Ring, Echo, and offers medical services. According to the Global Industry Standard (GICS) sector definitions, Amazon is not in the technology sector. (It is defined as a Consumer Discretionary company.) While sectors can provide a high-level understanding of similar businesses, sometimes these definitions are too blunt an instrument.
At the same time, economic forces can make some stocks expensive or cheap, experience winning or losing trends, and be exposed to financial stress for more highly levered companies – simultaneously affecting stocks across different sectors. Factor investing drills through broad labels to highlight what investors may care about and to help understand past performance and expected returns. These characteristics include absolute and relative price (size and value), the quality of a company’s earnings, trends in company performance (momentum), and the absolute and relative risk of a company (minimum volatility).
Factor Returns
The five factors of value, quality, momentum, minimum volatility, and small size are all supported by empirical data and peer-reviewed research.1 These factors have not only shown positive excess returns or reduced risk in the initial research, but they have also survived out of sample. Historically, each of these five factors has outperformed its counterpart – large size, higher priced companies, less profitable firms, downward trending stocks, higher risk securities – over varying time periods.
Exhibit 1: % of periods that factor outperformed counterpart
Source: Analysis by BlackRock using Ken French data library (https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html) and AQR data set (https://www.aqr.com/Insights/Datasets/Betting-Against-Beta-Equity-Factors-Monthly) as of 1/31/23. Data from July 1963 through January 2023. Low size represented by SMB (small minus big). Value represented by HML (high book-to-market minus low book-to-market). Quality represented by RMW (robust minus weak). Momentum represented by MOM (high prior returns minus low prior returns). Min Vol represented by BAB (betting against beta). Counterparts for low size, value, quality, momentum, and min vol are larger firms, higher priced stocks, less profitable stocks, downward trending stocks, and higher beta securities. Broad equities represented by Mkt-Rf which takes the return of equities and subtracts out the risk-free rate.
Investors can contrast factors with sectors or industries, which have not exhibited significant long-term excess returns above the market.2
Exhibit 2: Reward to Risk Ratio of Factors compared to Industries
Source: Analysis by BlackRock using Ken French data library and CRSP database from July 1963 through April 2023. Size represented by SMB (small minus big). Value represented by HML (high book-to-market minus low book-to-market). Quality represented by RMW (robust minus weak). Momentum represented by MOM (high prior returns minus low prior returns). Industries are represented by Consumer Non Durables, Consumer Durables, Manufacturing, Energy, Chemicals, Technology, Communications, Utilities, Retail, Health, Finance, and Other. Industry returns are calculated as excess returns which measure the industry returns in excess of the market. Reward-to-risk ratio is calculated by taking the average return of each factor/industry and dividing by its volatility. A higher reward to risk ratio implies a higher historical return relative to volatility.
There is little evidence that constant, strategic allocations to sectors give a significant compensated return in portfolios in excess of the market. In contrast, factors can give a long-run strategic source of potential returns. In addition, time-varying factor positions can be used to dynamically generate returns in a complementary way to time-varying sector positions.
Factors premiums within sectors
Investors seeking to capture factor premiums can consider whether to take a sector neutral or sector unconstrained approach. For factors that rely on fundamental variables, like quality and value, it may be prudent to apply sector constraints. When using balance sheet and earnings statement data, sector-specific treatment of earnings or book value in constructing factors allow more consistent comparison of companies within each sector. Investors may desire high quality and lower priced stocks across all sectors without unintended sector bets.
It’s important to highlight that sector neutral does not equate to industry neutral. A focus on quality can lead to overweights within industries while still remaining sector neutral to the broad market. For example, within the financials sector, banks have often scored poorly on quality metrics due to their levered business models.
Exhibit 3: Sector neutral does not equal industry neutral
Source: FactSet as of 6/1/23. Quality is proxied by the MSCI USA Sector Neutral Quality Index
The MSCI USA Sector Quality Index maintains a sector neutral weight to its parent index3 at each rebalance. As the index methodology considers leverage as one of its three quality screens (the other two are earnings variability and return on equity), the index was able to largely avoid the banking crisis in 2023 by holding no banks, while still remaining sector neutral within the financials sector. This has meant that the quality factor has avoided the stresses in regional banks so far this year.
Factors express a complementary view
The sector-controlled or sector-neutral definitions of factors can allow investors (e.g., institutional, advisor, end investor) who dynamically allocate to factors access to a complementary source of returns compared to investors doing sector rotation.
Traditionally, many active managers, asset allocators, and individual investors have expressed tactical views by rotating across sectors in hopes of generating alpha. In some cases, they want companies perceived to be “safe havens” such as utilities or consumer staples if they believe we are headed towards an economic slowdown or recession. In many cases, what these investors are actually looking for is exposure to companies with defensive characteristics that may add resiliency to their portfolios. They want companies that are less volatile (minimum volatility) or have lower amounts of leverage and more stable earnings growth (quality).
Exhibit 4: Sector Rotation vs. Factor Tilting
For illustrative purposes only
Factors naturally align with how institutional class investors think about the market.
Investors that are able to evolve their views from traditional sector labels to factors may be able to express a complementary view in their portfolio – and more importantly, allow them to capture the underlying exposure they are seeking.
Conclusion
It’s not factors versus sectors. It’s factors and sectors.
Sector neutral implementation of Factors, like value and quality, can allow investors to harvest a long-run rewarded factor return that is different from the returns of sectors. Likewise, factor rotation strategies can be used alongside sector rotation strategies as differentiating sources of returns.
In a post “Great Moderation” world, inflation has been persistent and is still well above 2% across most global markets, real rates are significantly positive, geopolitical tensions are flaring, and government deficit to GDP ratios are at the same level as during World War II – investors could use all possible sources of diversification and return drivers in their portfolios. Using factors alongside traditional sector strategies can help provide additional diversification.
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