Time to read: 4 min
In my interactions with clients, I have noticed a desire to examine the valuation of investment factors such as low volatility, quality, dividend yield and momentum. Many investors look at investment factors as they would a stock, with the belief that factors have intrinsic value and can be analyzed using price ratios such as price-to-sales or price-to-book. However, there are problems with applying traditional valuation analysis to factors.
Why are factors so difficult to value?
Valuing factors can be problematic for two reasons:
1. The holdings within a factor-based portfolio change over time. As an example, the screening process for stocks with momentum or low volatility characteristics typically leads to high turnover; the holdings in a factor-based portfolio are often very different now than they were a few quarters ago. Low volatility, as represented by the Invesco S&P 500 Low Volatility ETF (SPLV), has seen turnover as high as 65%, while momentum, as defined by the Invesco DWA Momentum ETF (PDP), has seen turnover as high as 100%.1
Factor-based portfolios differ from common stock in that stocks typically represent a finite set of assets. A company’s management is tasked with deploying its assets in a manner that maximizes profits and shareholder value. Corporate assets have an intrinsic value, and the impact of any changes will affect a company’s stock price. These assets are sticky and not subject to the turnover dynamic present in a factor-based portfolio. Conversely, the stocks in a factor-based portfolio are not sticky and may have no future impact because those stocks might be removed from the portfolio.
2. Factor portfolio performance can be influenced by economic and market conditions. This tends to happen over shorter time periods, despite factors’ ability to generate excess return over longer-term market cycles. For example, the momentum factor has the potential to shine when asset correlations are low and there is clear and sustained market leadership. Conversely, momentum can face headwinds when equity returns are highly correlated. Consider, too, the low volatility factor, which tends to outperform when volatility is high (markets are under stress), and to lag when volatility is low or falling.2 As a result, economic and market conditions are likely to be more impactful than valuations on short-term performance. Performance variations in different market conditions are one reason investors think about combining factors within an overall portfolio for purposes of diversification.
If you can’t value factors, what about timing them?
So, if you can’t value a factor-based portfolio, which is ever-changing in its composition, is timing an option? While it is possible to time factors, most investors either lack the skill set or don’t want to expend the energy necessary to do so. For that reason, factor timing should really be left to an elite group of investors. In my view, the average investor is more likely to be successful with broad factor exposure and employing periodic rebalancing. Broad exposure to multiple factors helps to enhance portfolio diversification, while periodic rebalancing helps mitigate the risk that a portfolio will become overexposed to a single factor.3 Rebalancing can be accomplished by trimming exposure to prevailing market winners, while allocating new assets to underperforming factors. But in the end, valuing factors is more of an art than an exact science.
For those interested in factor timing, look at long-term performance trends
As I mentioned earlier, factors can outperform over long periods, but are subject to cyclical performance over shorter time periods. Consequently, there may be an opportunity for investors to tilt either toward or away from a factor, depending on the factor’s stage within the performance cycle. To illustrate, consider the Invesco Dynamic Large Cap Value ETF (PWV). PWV has provided access to the value factor since its inception in March 2005 and, as shown in the chart below, has moved through a number of market cycles in that time. This is typical of most any factor.
Invesco Dynamic Large Cap ETF performance
As you can see, since March 2006 PWV has outpaced the S&P 500 Index by an average of nearly 150 basis points — consistent with the view held by market practitioners and academics that value is a rewarded factor. The straight red line on the graph displays this average historical excess return. (From March 2005 through September 2007, PWV gained 10.01%, while the S&P 500 Index returned 8.51%.) Despite the positive excess return, however, the blue 12-month rolling excess return curve indicates that there have been periods when PWV sharply outperformed and dramatically underperformed. While past performance is not a guarantee of future results, this historical performance cycle may provide insights into PWV’s potential performance in coming periods.
Looking at a fund’s highs and lows can provide valuable insights
The graph above indicates that PWV’s 12-month rolling excess return has spent limited time either below –5% or above 6%. In fact, since March 2006, PWV’s 12-month rolling excess return ranged between –5% and 6% nearly 75% of the time. What does this mean for timing? On balance, it’s fair to conclude that PWV starts to look “expensive” and is likely to mean revert lower when it spends time at or above 6%, and it starts to look “inexpensive” and is likely to mean revert higher when it is at or below –5%. At least that has been the case historically.
In this case, the data indicate that factor returns were not at extremes for long periods of time. You can also see from the blue line in the chart that the large-cap value factor was rarely able to outpace its benchmark by 10%. Markets show inefficiencies, but probably not at wide extremes, and the economic conditions that favor a factor are likely to come and go, despite being hard to predict. The economy is cyclical just like a factor — it goes through periods of both strong and weak growth relative to historical averages.
To sum it up, valuing factors is difficult on many levels. An investor who chooses factor timing as an alternative may want to think about the cycle of excess return in framing valuations and tilt toward or away from a factor as its excess return is approaching historical extremes. A period of low excess return may provide a catalyst for tilting toward a factor (increasing exposure), while a period of high excess return may provide a catalyst for tilting away from a factor (decreasing exposure).
Investors interested in gaining access to the large-cap value factor may wish to consider the Invesco Dynamic Large Cap Value ETF (PWV).
Blog header image: iJeab/Shutterstock.com
1 Source: Invesco S&P 500 Low Volatility ETF and Invesco DWA Momentum ETF prospectuses
2 Source: S&P Dow Jones Indices, January 2017
3 Diversification does not guarantee a profit or eliminate the risk of loss. There is no assurance that any investment or strategy will achieve its investment objective, nor should this be considered a guarantee of future performance or success of any strategy or product.
A basis point is one hundredth of a percentage point.
Correlation is the degree to which two securities or investments have historically moved in relation to each other.
Price-to-book ratio is calculated by dividing the market price of a stock by the book value per share.
Price-to-sales ratio is a valuation metric calculated by dividing a company’s market capitalization by its total sales over a 12-month period.
Dividend yield is the amount of dividends paid over the past year divided by a company’s share price.
Intrinsic value represents the estimated business value of a company or stock based on fundamental analysis and exclusive of market value.
The low volatility factor uses volatility rankings while seeking to minimize the effects of market fluctuations. Of course, low volatility cannot be guaranteed.
The momentum factor ranks securities relative to peers, using relative strength methodology to identify the strongest and weakest investment trends. Momentum style of investing is subject to the risk that the securities may be more volatile than the market as a whole or returns on securities that have previously exhibited price momentum are less than returns on other styles of investing.
The quality factor ranks the long-term growth and stability of a company’s earnings and dividends.
There are risks involved with investing in ETFs, including possible loss of money. Shares are not actively managed and are subject to risks similar to those of stocks, including those regarding short selling and margin maintenance requirements. Ordinary brokerage commissions apply. The fund’s return may not match the return of the underlying index. The fund is subject to certain other risks.
Please see the current prospectus for more information regarding the risk associated with an investment in the fund.
A value style of investing is subject to the risk that the valuations never improve or that the returns will trail other styles of investing or the overall stock markets.
Investments focused in a particular industry or sector, such as financials and technology, are subject to greater risk and are more greatly impacted by market volatility than more diversified investments.
Investing in securities of large-cap companies may involve less risk than is customarily associated with investing in stocks of smaller companies.
Factor investing is an investment strategy in which securities are chosen based on certain characteristics and attributes.
Shares are not individually redeemable, and owners of the shares may acquire those shares from the fund and tender those shares for redemption to the fund in creation unit aggregations only, typically consisting of 10,000, 50,000, 75,000, 100,000 or 200,000 shares.
Senior Equity Product Strategist
Nick Kalivas is a Senior Equity Product Strategist representing Invesco’s exchange-traded funds (ETFs). In this role, Nick works on researching, developing product-specific strategies and creating thought leadership to position and promote the smart beta* equity line up.
Prior to joining Invesco, Mr. Kalivas spent the majority of his career in the futures industry, delivering research, strategy and market intelligence to institutional and high net worth clients centered in the equity and interest rate markets. He was a featured contributor for the Chicago Mercantile Exchange, and provided research services to a New York-based global macro commodity trading advisor where he supplied insight on equities, fixed income, foreign exchange and commodities. Nick has been quoted in the Wall Street Journal, Financial Times, Reuters, New York Times and by the Associated Press, and has made numerous appearances on CNBC and Bloomberg.
Nick has a BBA in accounting and finance from the University of Wisconsin – Madison and an MBA from the University of Chicago Booth School of Business with concentrations in economics, finance, and statistics. He holds the Series 7 and Series 63 registrations.