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Factor basics

(Re)introducing factors

Factors are the underlying characteristics that drive investment performance, and they are woven into almost every investment. Factors aren't a recent development. Benjamin Graham and David Dodd published ideas on what we now call value investing in 1934's Security Analysis.¹ Today, value investing is considered a factor strategy.

What is new about factor-based investing is using the factor lens to evaluate portfolios. An investor's portfolio might tilt towards or away from certain factors without the investor even realising it, and viewing portfolios through this lens allows us to credit factors for their effects on risk and return.

The evolution of equity attribution models

Evolution Chart

Notes: This is a hypothetical scenario for illustrative purposes only. It does not represent any particular equity investment. "Noise" refers to the fact that through any period, some degree of randomness always affects results versus the broad equity market. The degree of influence varies and can be difficult to statistically distinguish from alpha without extensive data.
Source: Vanguard.

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This is a bar chart with four bars representing the evolution of equity attribution models over time. The x-axis represents percentage of equity attribution, and y-axis represents time. All bars total 100%, and proportions within each bar are gestural and not exact.

The first bar shows that, when investment research began, all sources of equity investment variation were attributed to manager skill and market noise.

The second bar represents the first evolution of the attribution model. Beta now makes up about 80% of the equity attribution, and alpha (formerly manager skill) and market noise make up the remaining 20%.

The third bar represents the second evolution of the model. Beta has been reclassified as "market factor" and still makes up about 80% of the equity attribution. The remainder is attributed to "size and value factors" (about 15%) and pure alpha and noise (about 5%).

The fourth bar represents the current model. The market factor still makes up about 80% of the equity attribution. Size and value factors have been reclassified as "style factors" to include other factors like liquidity and momentum, increasing its share of equity attribution from about 15% to about 18%. Pure alpha and noise make up the remaining 2%.

The better we've gotten at understanding what drives active managers' returns, the less we have attributed to active managers' stock-selection skills.

Factor strategies take this analysis a step further by leveraging the positive effects of factor exposures through systematic, diversified and disciplined tilts.

Harnessing factor exposures

Academic research has identified hundreds of factors, and many investor portfolios may reflect a number of factors, but few produce a long-term premium. Only factors that display an enduring, logical rationale; are backed by empirical evidence; and demonstrate investability after costs are worth tilting towards.

Value

Inexpensive stocks have tended to earn a higher return than expensive stocks.2

Some investors require a cheaper price to invest in companies sensitive to economic shocks.3

Momentum

Stocks with strong recent performance have tended to earn a higher return than those with weak recent performance.2

Some investors underreact to company-related information in the short term and overreact to company-related information in the medium-term.3

Quality

Stocks of companies with stronger operational earnings and balance sheet quality have tended to earn a higher return than those that do not.2

Some investors avoid "boring" stocks that exhibit steady, profitable growth.3

Liquidity

Stocks with less liquidity have tended to outperform stocks with higher liquidity.2

Some investors are willing to pay a premium on stocks with more predictable price impact costs.3

Multifactor

Multifactor products offer potential diversification benefits that can help reduce the active risk associated with exposure to a single factor.

Multifactor products capture interactions among factors to offer more balanced exposures and help create a reliable potential for outperformance.

Minimum Volatility

A group of stocks that together generate lower volatility relative to the broad equity market.

Minimum volatility products aim to minimise volatility in fully-invested equity portfolios. This can result in lower volatility and returns while still offering the potential for higher risk-adjusted returns over the long term.

Achieving factor exposure

As an advisor, you can help demonstrate your value and expertise to your clients by successfully implementing tilts toward viable factors in a portfolio, regardless of vehicle.

Style index funds and ETFs

  • Moderate factor exposure
  • Capitalization weighting
  • Low—moderate cost
  • High transparency
  • Moderate tracking error
  • Low manager risk

Traditional active funds

  • Low—moderate factor exposure
  • Proprietary weighting
  • Low—high cost
  • Low—moderate transparency
  • Low—high tracking error
  • Opportunity for alpha
  • Low—high manager risk

Factor funds and ETFs

  • High factor exposure
  • Rules-based weighting
  • Low to moderate cost
  • Moderate to high transparency
  • Moderate to high tracking error
  • Low manager risk

Recognising the risks

Using factor products can help investors implement a transparent, controlled active approach towards meeting their goals. But factor investing isn't without risks.

Factors can experience sustained periods of underperformance. Factor-timing is extremely difficult, and strategies that attempt to do so are ill-advised. So it's important to have the long-term patience needed to stick with an equity factor-based investing strategy.

For more on the cyclical nature of factor performance, see Equity factor-based investing: A practitioner's guide.

Factors research cornerstones

1 Benjamin Graham and David Dodd, 1934. Security Analysis. New York: The McGraw-Hill Companies, Inc.
2 Scott N. Pappas and Joel M. Dickson, 2015. Factor-based investing. Valley Forge, Pa.: The Vanguard Group.
3 Risk and/or behavioural rationale represents one of several potential reasons cited in academic literature that may cause these factors to generate excess net returns in the future.

Important information:

Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

Diversification does not ensure a profit or protect against a loss.

All investing is subject to risk, including possible loss of principal.

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from broader stock markets.

Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

This material is for distribution to "Professional Investors" (as defined in the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) and any rules made under that ordinance) only. It is not intended for and should not be distributed to, or relied upon, by members of the public or retail investors in Hong Kong.

The contents of this document and any attachments/links contained in this document are for general information only and are not advice. Investment involves risks. Past performance is not indicative of future results. The information does not take into account your specific investment objectives, financial situation and individual needs and is not designed as a substitute for professional advice. You should seek independent professional advice regarding the suitability of an investment product, taking into account your specific investment objectives, financial situation and individual needs before making an investment.

The contents of this document and any attachments/links contained in this document have been prepared in good faith. Please note that the information may have become outdated since its publication, and any information sourced from third parties is not necessarily endorsed by The Vanguard Group, Inc., and all of its subsidiaries and affiliates (collectively, the "Vanguard Entities").

This document contains links to materials which may have been prepared in the United States and which may have been commissioned by the Vanguard Entities. They are for your information and reference only and they may not represent our views. The materials may include incidental references to products issued by the Vanguard Entities.

The information contained in this document does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The Vanguard Entities may be unable to facilitate investment for you in any products which may be offered by the Vanguard Group, Inc.

No part of this document or any attachments/links contained in this document may be reproduced in any form, or referred to in any other publication, without express written consent from the Vanguard Entities. Any attachments and any information in the links contained in this document may not be detached from this document and/or be separately made available for distribution.

This document is being made available in Hong Kong by Vanguard Investments Hong Kong Limited (CE No. : AYT820) ("Vanguard Hong Kong"). The contents of this document have not been reviewed by the Securities and Futures Commission in Hong Kong.

Our difference

Our actively managed, rules-based approach to factors allows you to harness well-known factor exposures in a more transparent and low-cost way.

Our factor products are managed by Vanguard's in-house Quantitative Equity Group (QEG). QEG has deep expertise in applying rules-based, quantitative investing that is backed by more than 25 years of experience.

Meet our factor experts

 Read transcript

Determining which factors to use

300+ documented characteristics, 5 Vanguard funds

At Vanguard, a factor must meet three criteria to be considered viable for targeting:

Enduring, logical rationale

A factor must display an enduring, logical rationale for investing, for either risk-based or behavioural reasons.

Empirical evidence

A factor's chances of helping an investor meet an objective must be backed by solid empirical evidence, such as out-of-sample tests or academic studies.

Investability

A factor must be investable. The reward must be worth the risk once real-world implementation costs enter the equation (expense ratio, bid-ask spreads and taxes).

More than 300 factors have been documented in the academic literature. Five of the most well-known factors that can be targeted, when relying on the three criteria listed above, are: value, momentum, quality, liquidity and minimum volatility.

Building our single-factor products

The methodology we employ to build our factor portfolios helps us to achieve a broader and stronger factor exposure that is more diversified across individual stocks, giving us greater flexibility to maintain consistent exposure over time.

We believe that factor-based strategies should prioritise broader diversification and stronger factor exposure above all else.

Assess the opportunities

Our quantitative process analyses thousands of stocks each day.

Calculate the factor score

Each stock is evaluated on commonly recognised metrics per single-factor fund.

Create the portfolio

High-scoring stocks are included in the portfolio and weighted according to their score.

Building a minimum volatility product

  • Employ quantitative models to minimise volatility while limiting exposure to common risk factors.
  • Assess the volatility of individual stocks, in addition to examining the correlation of returns among stocks.
  • Put risk controls in place around sectors, individual stock weights and other considerations to help ensure diversification and liquidity.

Building multifactor products

illustration of bottom-up construction
illustration of bottom-up construction
Read image description 

A multicoloured circle that represents the equities market is shown in three phases. The first phase is a full circle. The second phase removes the market’s most volatile stocks, resulting in a partially filled circle. The third phase arranges the remaining three factor exposures by factor score, and their overlap is highlighted to represent a multifactor product's target exposure.

When it comes to our multifactor offerings, we employ a bottom-up construction. This means that the portfolio is based on a selection of equities that provide positive exposure to the desired factors, combined into a single product.

A volatility filter is used to first screen out the most volatile stocks from the initial universe. The remaining stocks are assigned a composite factor score based on equally weighting their value, momentum and quality scores.

This technique may lead to lower turnover and can help ensure that chosen stocks are not inadvertently tilted against the targeted factors.

Bottom-up multifactor products

  • Outsource factor decisions.
  • Capture interaction effects between factors.
  • Provide ease of implementation.

Vanguard's strengths

Mitigating drift

QEG portfolio managers continually monitor our factor products to help ensure the targeted exposure does not drift through time. Unlike many competitors' products, our factor exposures are assessed daily and rebalanced as needed to lessen factor decay.

Diversifying exposure

Market-cap weighting has its advantages, and many factor products on the market are built that way. But we believe equity factor-based strategies should prioritise the degree of exposure above all else.

Our portfolios are designed to provide a high level of diversification while reducing exposure to individual-security risk and intensifying exposure to the targeted factor. This control can help you further customise the tilt to factor exposures that can help investors meet their long-term goals.

Leveraging experience

We've been managing factor ETFs outside the United States since 2015 and launched our US-domiciled factor ETFs in 2018. Our global experience has helped us deliver factor-based strategies that resonate with investors' needs.

Factors research cornerstones

Important information:

Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

Diversification does not ensure a profit or protect against a loss.

All investing is subject to risk, including possible loss of principal.

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from broader stock markets.

Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

This material is for distribution to "Professional Investors" (as defined in the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) and any rules made under that ordinance) only. It is not intended for and should not be distributed to, or relied upon, by members of the public or retail investors in Hong Kong.

The contents of this document and any attachments/links contained in this document are for general information only and are not advice. Investment involves risks. Past performance is not indicative of future results. The information does not take into account your specific investment objectives, financial situation and individual needs and is not designed as a substitute for professional advice. You should seek independent professional advice regarding the suitability of an investment product, taking into account your specific investment objectives, financial situation and individual needs before making an investment.

The contents of this document and any attachments/links contained in this document have been prepared in good faith. Please note that the information may have become outdated since its publication, and any information sourced from third parties is not necessarily endorsed by The Vanguard Group, Inc., and all of its subsidiaries and affiliates (collectively, the "Vanguard Entities").

This document contains links to materials which may have been prepared in the United States and which may have been commissioned by the Vanguard Entities. They are for your information and reference only and they may not represent our views. The materials may include incidental references to products issued by the Vanguard Entities.

The information contained in this document does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The Vanguard Entities may be unable to facilitate investment for you in any products which may be offered by the Vanguard Group, Inc.

No part of this document or any attachments/links contained in this document may be reproduced in any form, or referred to in any other publication, without express written consent from the Vanguard Entities. Any attachments and any information in the links contained in this document may not be detached from this document and/or be separately made available for distribution.

This document is being made available in Hong Kong by Vanguard Investments Hong Kong Limited (CE No. : AYT820) ("Vanguard Hong Kong"). The contents of this document have not been reviewed by the Securities and Futures Commission in Hong Kong.

Factor applications

When constructing a portfolio, factor exposure can be achieved by using a variety of investment options, including style index funds, low-cost active funds or factor funds and ETFs.

Here are several examples of how equity factor-based investing can be applied in real-world portfolio construction.

Substitution for high-cost active

This hypothetical illustration is for representative purposes only.

Read chart description 

Comparison of two hypothetical funds: A high-cost active fund and a factor fund. The sources of the funds' equity return variation are represented by donut charts.

The first chart shows a high-cost active fund with ongoing charges (per annum) of 1.12%. About two-thirds of the fund's performance variation can be attributed to market exposure. Most of the remaining third is attributed to style factors, while manager alpha accounts for an insignificant sliver of return variation. Hence, the active manager's stock-selection skill isn't influencing performance.

The second chart shows a factor fund with ongoing charges (per annum) of 0.09%. About two-thirds of the fund's performance variation can be attributed to market exposure. The remainder is attributed to the same style factors as the traditional active fund.

Since the factor fund can replicate the performance of the traditional active fund at a much lower cost, it would be a good candidate for substitution.

Opportunity

Is an investor overpaying an active manager just to get factor exposure?

After analysing the investor's portfolio, it is apparent that the manager's returns are largely explained by common factor exposures. Findings from the analysis include:

  • Factor exposure has been constant over time.
  • No additional return has been added through security selection or market-timing.
  • The manager was unable to overcome the high-cost hurdle.

Strategy

In this case, the investor should keep the desired factor exposure, but at a lower cost, by replacing the high-cost active manager with a low-cost factor product.

Potential benefits

  • Cost savings.
  • More targeted exposure to a desired factor.
  • Greater transparency.

Caveats

  • Not all active funds are good candidates for substitution.

Works with these factors

Value
Liquidity
Momentum
Multifactor
Quality
Minimum volatility
Enhance return

This hypothetical illustration is for representative purposes only.

Read chart description 

Comparison of two hypothetical portfolios: An index-based portfolio and a mostly index-based portfolio that uses factor products to create an equity factor tilt. The portfolios' factor exposures are represented by donut charts.

The first chart shows an index-based portfolio designed to track the market. Since market exposure is the only source of return variation, there is no chance for the portfolio to outperform.

The second chart shows the effects of adding an equity factor tilt to the hypothetical portfolio. Value and momentum now account for about 10% of the portfolio, creating an opportunity for the portfolio to outperform the market.

Opportunity

An investor seeks to outperform the equity market over a long time horizon.

Typically, index funds are used to gain equity market exposure. While this approach keeps costs low and helps create more predictable results, many investors are drawn to the allure of outperforming the market with an active manager. Traditional active management can outperform over time, but the challenge for investors is to find talented active managers at a reasonable cost.

Strategy

Use an equity tilt towards a factor that may help achieve outperformance goals in a cost-efficient manner.

Potential benefits

  • More control over performance drivers versus traditional active management.
  • No reliance on an active manager's stock-selection skills.
  • Lower costs and greater transparency than traditional active management.

Caveats

  • Any given factor may underperform the market for a significant period of time.
  • There is no guarantee the factor tilt will improve long-term results.

Works with these factors

Value
Liquidity
Momentum
Multifactor
Quality
Reduce volatility

This hypothetical illustration is for representative purposes only.

Read chart description 

Comparison of two hypothetical portfolios: A stock-based portfolio with high levels of risk and a stock-based portfolio that makes a significant allocation to a minimum volatility product. Each portfolio is represented by a donut chart.

The first chart shows a stock-based portfolio, and the second chart shows the effects of adding a minimum volatility factor tilt to it. With about a third of the portfolio allocated to a minimum volatility product, the risk level in the second portfolio is lower than the risk level in the first.

Opportunity

An investor is looking for ways to reduce portfolio volatility while remaining invested in stocks.

An evaluation of the investor's portfolio indicates that the investor should shift some equity exposure into a more conservative approach that helps reduce overall portfolio risk. Rather than shifting assets away from equities into fixed income, the investor could allocate a portion into a minimum-volatility strategy.

Strategy

Use a minimum volatility tilt to help reduce the absolute risk in a portfolio over the long term.

Potential benefits

  • Low-cost way to dampen volatility.
  • More control over risk exposure.
  • Potential for higher risk-adjusted returns.

Caveats

  • Long-term returns will likely trail the broad market.
  • Potential for higher tracking error.

Works with these factors

Minimum volatility
Calibrate factor exposure

This hypothetical illustration is for representative purposes only.

Read chart description 

Comparison of two hypothetical portfolios: One whose factor exposure levels are not calibrated to an investor's tolerance levels, and one whose factor exposures are calibrated. The portfolios' factor exposures are represented by donut charts.

Opportunity

Factor exposures don't fit an investor's tolerance range or long-term plan.

An investor's equity portfolio was built using broad-market indices and active managers. Despite performing proper due diligence during construction, a recent analysis revealed one or more of the following:

  • Active decisions that resulted in unintended factor exposures.
  • A particular factor exposure that now exceeds the investor's tolerance range.
  • Adjusting exposures can help align the portfolio with the investor's goals.

Strategy

Sell a portion of the traditional active assets and put the proceeds towards products that will help balance the portfolio's factor exposures.

Potential benefits

  • Better align factor exposures with investor preferences.
  • Help control unwanted risk exposures that may occur as a by-product of active decisions.

Caveats

  • Factor exposure is time-variant.
  • Recurring maintenance or rebalancing might be required.

Works with these factors

Value
Liquidity
Momentum
Quality
Minimum volatility

Factors research cornerstones

Important information:

Funds that concentrate on a relatively narrow market sector face the risk of higher share-price volatility.

Diversification does not ensure a profit or protect against a loss.

All investing is subject to risk, including possible loss of principal.

Factor funds are subject to investment style risk, which is the chance that returns from the types of stocks in which the fund invests will trail returns from broader stock markets.

Factor funds are subject to manager risk, which is the chance that poor security selection will cause the fund to underperform relevant benchmarks or other funds with a similar investment objective.

This material is for distribution to "Professional Investors" (as defined in the Securities and Futures Ordinance (Cap. 571 of the laws of Hong Kong) and any rules made under that ordinance) only. It is not intended for and should not be distributed to, or relied upon, by members of the public or retail investors in Hong Kong.

The contents of this document and any attachments/links contained in this document are for general information only and are not advice. Investment involves risks. Past performance is not indicative of future results. The information does not take into account your specific investment objectives, financial situation and individual needs and is not designed as a substitute for professional advice. You should seek independent professional advice regarding the suitability of an investment product, taking into account your specific investment objectives, financial situation and individual needs before making an investment.

The contents of this document and any attachments/links contained in this document have been prepared in good faith. Please note that the information may have become outdated since its publication, and any information sourced from third parties is not necessarily endorsed by The Vanguard Group, Inc., and all of its subsidiaries and affiliates (collectively, the "Vanguard Entities").

This document contains links to materials which may have been prepared in the United States and which may have been commissioned by the Vanguard Entities. They are for your information and reference only and they may not represent our views. The materials may include incidental references to products issued by the Vanguard Entities.

The information contained in this document does not constitute an offer or solicitation and may not be treated as an offer or solicitation in any jurisdiction where such an offer or solicitation is against the law, or to anyone to whom it is unlawful to make such an offer or solicitation, or if the person making the offer or solicitation is not qualified to do so. The Vanguard Entities may be unable to facilitate investment for you in any products which may be offered by the Vanguard Group, Inc.

No part of this document or any attachments/links contained in this document may be reproduced in any form, or referred to in any other publication, without express written consent from the Vanguard Entities. Any attachments and any information in the links contained in this document may not be detached from this document and/or be separately made available for distribution.

This document is being made available in Hong Kong by Vanguard Investments Hong Kong Limited (CE No. : AYT820) ("Vanguard Hong Kong"). The contents of this document have not been reviewed by the Securities and Futures Commission in Hong Kong.