In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the main actors of the smart beta industry, which is estimated to represent a cumulative market value of $1.9 trillion as of 2017 and is projected to grow to $3.4 trillion by 2022 (BlackRock, 2021).

The structure of this post is as follows: we begin by presenting an overview of the smart beta industry actors. We will then discuss the case of BlackRock, the 10 trillion dollar powerhouse of the asset management industry, which is the main actor in the smart beta industry segment.

Overview of the market

The asset management sector, which is worth 100 trillion dollars worldwide, is primarily divided into active and passive management (BCG, 2021). While active management continues to dominate the market, passive management’s proportion of total assets under managed (AUM) increased by 4 percentage points between 2008 and 2019, reaching 15%. This market transition is even more dramatic in the United States, where passive management accounted for more than 40% of the total market share in 2019. A new category has arisen and begun to acquire market share over the last decade. Smart beta exchange-traded funds (ETFs) are receiving fresh inflows and are the industry’s fastest-growing ETF product. Various players are entering the market by developing and releasing new products (Deloitte, 2021).

Active funds have demonstrated divergent returns when compared to passive funds, making the cost difference increasingly difficult to justify (Figure 1). The growing market share of passive funds in both the United States and the European Union is putting further pressure on active managers’ fees. When it comes to meeting the demands of investors, both active and passive management has shown shortcomings. Active management funds often fail to outperform their benchmarks because they lack clear indicators, charge expensive fees, and don’t always have clear indicators. As seen in Figure 1, active funds struggle to deliver consistent returns over a prolonged timeframe, as depicted in the European market. In this sense, the active funds success rate is divided by more than half between year one and year three (Deloitte, 2021). Concentration is a problem for passive funds that are weighted by market capitalization.. These limits have prepared the ground for smart beta funds to emerge (Figure 1).

Figure 1. Active funds success rates (% of funds beating their index over X years)

Source: Deloitte (2021).

The smart beta market is dominated by several players who have a strategic position with a large volume of assets under management. Figure 2 compares smart beta actors based on percentage of asset under management (%AUM), one the most important metric in the asset management industry. Some key elements can be drawn for the first figure. BlackRock is the provider with the largest market share, with over 40% of the smart beta industry in the analysis, followed by Vanguard and State Street Global Advisors with 30.66% and 18.44% respectively in this benchmark study underpinning nearly $1 trillion (Figure 2).

Figure 2. % AUM of the biggest Smart Beta ETF providers

Source: etf.com (2021).

BlackRock dominance

The main powerhouses of the passive investing industry, BlackRock and Vanguard, are poised to capture the lion’s share of assets in the rapidly rising world of actively managed exchange-traded funds. The conclusion is likely to dissatisfy active fund managers, who have been squeezed by the fast development of passive ETFs in recent years and may have seen the introduction of active ETFs as a chance to fight back and get a piece of the lucrative pie (Financial Times, 2021).

According to a study of 320 institutional investors with a combined $12.9 trillion in assets, institutional investors prefer BlackRock and Vanguard to handle their active ETF investments. The juggernauts were expected to provide the best performance as well as the best value for money. With over a third of the global ETF market capitalization, BlackRock remains the dominant player (The Financial Times, 2021). BlackRock is unquestionably a major force in the ETF business, with an unparalleled market share in both the US and European ETF markets. BlackRock has expanded to become the world’s largest asset manager, managing funds for everyone from pensioners to oligarchs and sovereign wealth funds. It is now one of the largest stockholders in practically every major American corporation — as well as a number of overseas corporations. It is also one among the world’s largest lenders to businesses and governments.

Aladdin, the company’s technological platform, provides critical wiring for large portions of the worldwide investing industry. By the end of June this year, BlackRock was managing a stunning $9.5 trillion in assets, a sum that would be hardly understandable to most of the 35 million Americans whose retirement accounts were managed by the business in 2020. If the current rate of growth continues, BlackRock’s third-quarter reports on October 13 might disclose that the company’s market capitalization has surpassed $10 trillion. It’s expected to have surpassed that mark by the end of the year (FT, 2021). To put this in perspective, it is about equivalent to the worldwide hedge fund, private equity, and venture capital industries combined.

Industry-wide fee cuts had helped BlackRock maintain its dominance in the ETF sector. Its iShares brand is the industry’s largest ETF provider for both passive and actively managed products (CNBC, 2021).

Why should I be interested in this post?

If you are a business school or university undergraduate or graduate student, this content will help you in understanding the various evolutions of asset management throughout the last decades and in broadening your knowledge of finance.

Smart beta funds have become a trending topic among investors in recent years. Smart beta is a game-changing invention that addresses an unmet need among investors: a higher return for lower risk, net of transaction and administrative costs. In a way, these investment strategies create a new market. As a result, smart beta is gaining traction and influencing the asset management industry.

Related posts on the SimTrade blog

Factor investing

   ▶ Youssef LOURAOUI Factor Investing

   ▶ Youssef LOURAOUI Origin of factor investing

   ▶ Youssef LOURAOUI MSCI Factor Indexes

   ▶ Youssef LOURAOUI Smart beta 1.0

   ▶ Youssef LOURAOUI Smart beta 2.0

Factors

   ▶ Youssef LOURAOUI Size Factor

   ▶ Youssef LOURAOUI Value Factor

   ▶ Youssef LOURAOUI Yield Factor

   ▶ Youssef LOURAOUI Momentum Factor

   ▶ Youssef LOURAOUI Quality Factor

   ▶ Youssef LOURAOUI Growth Factor

   ▶ Youssef LOURAOUI Minimum Volatility Factor

Useful resources

Business analysis

BlackRock, 2021.What is factor investing?

BCG, 2021.The 100$ Trillion Machine: Global Asset Management 2021

CNBC, 2021. What Blackrock’s continued dominance means for other ETF issuers.

Deloitte, 2021. Will smart beta ETFs revolutionize the asset management industry? Understanding smart beta ETFs and their impact on active and passive fund managers

Etf.com, 2021.Smart Beta providers

Financial Times (13/09/2020) BlackRock and Vanguard look set to extend dominance to active ETFs

Financial Times (07/10/2021) The ten trillion dollar man: how Larry Fink became king of Wall St

About the author

The article was written in October 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Growth Factor

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the growth factor, which is based on a risk factor that aims to get exposure to firms with high growth potential based on a variety of parameters such as historical profits, sales, and expected earnings.

This article is structured as follows: we begin by defining the growth factor and reviewing academic studies. The MSCI Growth Factor Index, which is well used as a benchmark in the asset management industry, is next presented in terms of performance and risk-return trade-off. We showcase the ETF market for investors looking to profit from the growth factor.

Definition

In the world of investing, a factor is any aspect that helps explain an asset’s long-term risk and return performance. In the late 1970s, the portfolio management industry’s objective was to capture the market return on a portfolio. As a result of Markowitz and Tobin’s earlier research, William Sharpe, John Lintner, and Jan Mossin independently developed the Capital Asset Pricing Model (CAPM). Because it enabled investors to properly value assets in terms of systematic risk, the CAPM was a significant evolutionary step forward in the theory of capital market equilibrium (Mangram, 2013).

Eugene Fama and Kenneth French, following the CAPM’s original work, developed the Fama-French Three-Factor model in 1993 to solve the CAPM’s inadequacies. It claims that, in addition to the market risk component of the CAPM, two other factors have an effect on the returns on securities and portfolios: market capitalization (called the “size” factor) and the book-to-market ratio (referred to as the “value” factor). Other factor characteristics were developed to capture some additional performance as financial research advanced and significant contributions were made.

Academic research

The fundamental work of Fama and French may be traced back to the most significant academic works in the factor investing literature. Since the growth factor has a poor academic literature review, we will focus on the work of Fama and French (1993). In response to the CAPM’s limitations, Eugene Fama and Kenneth French developed the Fama-French three-factor model in 1993. It argues that, in addition to the market risk component provided by the CAPM, two additional factors, market capitalization (referred as “size”) and book-to-market ratio (referred as “value”), influence the returns on securities and portfolios. The major rationale for including these attributes, according to Fama and French, is that both size and book-to-market ratios are connected to the economic fundamentals of the firm issuing the securities (Fama and French, 1993).

In 2014, Fama and French claimed that their original three-factor model from 1993 was insufficient to explain certain observed differences in expected returns. As a result, Fama and French expanded their three-factor model to include two more factors: profitability and investment. The theoretical implications of the dividend discount model (DDM), which claim that profitability and investment contribute to the explanation of the returns derived from the High Minus Low premium element in the first model, justify these two aspects (Fama and French, 2015). High Minus Low can be defined as the value premium that accounts for the spread between the return of small capitalization stocks compared to large capitalization stocks.

Active managers have utilized the Growth factor to capture corporate growth possibilities using historical profits, sales, and anticipated earnings, and it has been employed as a possible source of alpha. The impact of unintended exposure, which shows that assets with strong growth can also have high valuations, high volatility, low yield, and bad quality, which can negatively influence portfolio performance, can be a difficulty when using simple selection methods to capture growth (MSCI Factor research, 2021).

Growth investing, often known as capital growth or capital appreciation, has been a prominent investment strategy since the 1950s and is one of active managers’ most intuitive and commonly used investment strategies (MSCI Factor research, 2021). Growth is a well-known investment strategy that, according to risk models, has a strong explanatory power in risk forecasting. In comparison to the MSCI ACWI Index, the pure growth factor has shown an impressive long-term return as well as low or negative correlation with other factors, which may assist diversify a multi-factor portfolio by minimizing short-term cyclicality.

Example of a “growth” stock

Any stock in a firm that is expected to expand at a pace significantly higher than the market average is considered a growth stock. Dividends are seldom paid on these stocks. This is because growth stock issuers are often businesses that seek to reinvest any profits in order to increase growth in the short term. When people buy growth stocks, they expect to profit from capital gains when they sell them later (Investopedia, 2021).

For instance, Amazon Inc. (AMZN) has been regarded as a growth stock for quite some time. It is, and has been for some time, one of the world’s largest companies in 2020. In terms of market value as of July 31, 2021, Amazon is among the top five U.S. stocks.

MSCI Growth Factor Index

MSCI Factor Indexes are rules-based, transparent indexes that target equities with favorable factor qualities, as determined by academic discoveries and empirical outcomes, and are designed for easy implementation, replicability, and usage in both standard indexed and active portfolios.

MSCI Growth Factor Index accounts for unexpected risks and exposures while also extending the notion of growth at a reasonable price (GARP) to include volatility, yield, and quality (MSCI Factor research, 2021). The impact of unintended exposure, which shows that assets with strong growth can also have high valuations, high volatility, low yield, and bad quality, which can negatively influence portfolio performance, can be a difficulty when using simple selection methods to capture growth. MSCI’s growth target index accounts for unexpected risks and exposures while also extending the notion of growth at a reasonable price (GARP) to include volatility, yield, and quality. Growth at a reasonable price (GARP), a long-held notion among growth investors, aims to avoid overpaying for a stock’s prospective growth. The GARP idea may be expanded by limiting value exposure, ensuring that the long-term premium for growth is not reduced by the unintentional and accidental impact of assets with high values, i.e., negative value exposure.

Performance of the MSCI Growth Factor Index

Figure 1 compares the MSCI Growth Factor Index’s performance to those of other factors from May 1999 to May 2020. All indices are rebalanced on a 100-point scale to ensure consistency in performance and to facilitate factor comparisons.

Figure 1. Performance of the MSCI Growth Factor Index from 1999-2020.

Source: MSCI Factor research, 2021.

Over the long run, the MSCI World Growth Index has traditionally delivered excess returns, with a yearly return of 1.41 percent over the MSCI World Index since 1999, as seen above. (MSCI Factor research, 2021).

Risk-return profile of MSCI Growth Factor Index

Figure 2 shows the MSCI Growth Factor Index compared to other factors over the period May 1999 – May 2020 in terms of risk/reward. The risk-return trade-off states that the potential return rises with an increase in risk. Individuals connect low levels of uncertainty about future returns with low potential returns, while high levels of uncertainty or risk are associated with large potential returns. According to the risk-return trade-off, an investor’s money can generate higher returns only if the investor is willing to endure a higher risk of loss and return (Figure 2).

Figure 2. Risk-return profile of MSCI Growth Factor Index compared to a peer group.

Source: MSCI Factor research, 2021.

Growth stocks are defined as firms that are projected to expand their sales, profits, or margins faster than the industry or market average. The growth factor may provide value to a multi-factor portfolio by mitigating short-term cyclicality and providing asset managers with diversity and a stable source of premia. MSCI developed the Growth Target Index, based on Barra’s equity index model characteristics, through an optimization process that captures the growth component while limiting unwanted exposures that might erode the growth premium (MSCI Factor research, 2021).

ETFs for the growth factor

Let us recall that an Exchange-Traded Fund (ETF) is an investment vehicle that seeks to mirror the performance of a benchmark like an equity index and is traded on a continuous basis during the day like stocks. By investing in ETFs, an investor gains access to a plethora of diversification options through several asset classes (equity, bonds, currency, commodity, real estate, etc.).

In terms of proportion of assets under management, Figure 3 depicts the total ETF distribution among the leading suppliers of growth factor ETFs. Despite the lack of a real monopoly, the market is more equally distributed.

It’s worth mentioning the ARK Innovation ETF, which accounts for almost a third of the entire growth ETF market that was nominated. This ETF invests on biotech, robotics, artificial intelligence, blockchain, and finance technology, among other areas. It’s a thematically focused fund that invests in a limited number of high-growth companies and makes large swings in them.

The fund’s top 10 holdings make up nearly half of the overall portfolio. The company’s largest investment is Tesla (TSLA), which accounts for about 11% of its assets, followed by Square (SQ), Teladoc Health (TDOC), and Roku (ROKU), which account for 6.5 percent, 6.3 percent, and 5.5 percent, respectively. The top 10 companies include Zillow Group (Z), Zoom Video Communications (ZM), Baidu (BIDU), Shopify (SHOP), Spotify Technology (SPOT), and Exact Sciences (EXAS). The ARK Innovation ETF (ticker: ARKK) had a 153 percent return in 2020 (etf.com, 2021).

Figure 3. Growth factor ETF market.

Source: etf.com (2021).

Table 1 gives more detailed information about the biggest growth factor ETF providers: the asset under management (AUM), expense ratio (ER) and the segment for the investments.

Table 1. Ranking of the biggest Growth ETF providers.

Source: etf.com (2021).

Why should I be interested in this post?

If you are an undergraduate or graduate student in a business school or at the university, you may have seen in your 101 finance course the CAPM related to the market factor. This post makes aware of the existence of another risk factor priced by the market.

If you are an investor, you may consider adding an exposure to growth factor to enhance the overall portfolio return.

Related posts on the SimTrade blog

   ▶ Youssef LOURAOUI Minimum Volatility

   ▶ Youssef LOURAOUI Value Factor

   ▶ Youssef LOURAOUI Yield Factor

   ▶ Youssef LOURAOUI Momentum Factor

   ▶ Youssef LOURAOUI Size Factor

   ▶ Youssef LOURAOUI Quality Factor

Useful resources

Academic research

Fama, E.F., French, K.R. 1992. The Cross-Section of Expected Stock Returns. The Journal of Finance, 47: 427-465.

Fama, E.F., French, K.R., A five-factor asset pricing model, Journal of Financial Economics, 116(1): 2015, 1-22.

Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.

Business analysis

etf.com, 2021. Biggest Growth ETF providers.

MSCI Investment Research, 2021. Factor Focus: Growth.

Investopedia, 2021. Growth Stock.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Quality Factor

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the quality factor, which is based on a risk factor that aims to get exposure to businesses with long-term business plans and competitive advantages.

This article is structured as follows: we begin by defining the quality factor and reviewing academic studies. The MSCI Quality Factor Index, which is well used as a benchmark in the asset management industry, is next presented in terms of performance and risk-return trade-off. We showcase the ETF market for investors looking to profit from the quality factor.

Definition

In the world of investing, a factor is any characteristic that helps explain an asset’s long-term risk and return performance. In the late 1970s, the portfolio management industry’s objective was to capture the market return on a portfolio. As a result of Markowitz and Tobin’s earlier research, William Sharpe, John Lintner, and Jan Mossin independently developed the Capital Asset Pricing Model (CAPM). Because it enabled investors to properly value assets in terms of systematic risk, the CAPM was a significant evolutionary step forward in the theory of capital market equilibrium (Mangram, 2013).

Eugene Fama and Kenneth French, following the CAPM’s original work, developed the Fama-French Three-Factor model in 1993 to solve the CAPM’s inadequacies. It claims that, in addition to the market risk component of the CAPM, two other factors have an effect on the returns on securities and portfolios: market capitalization (called the “size” factor) and the book-to-market ratio (referred to as the “value” factor). Other factor characteristics were developed to capture some additional performance as financial research advanced and significant contributions were made.

The quality factor is based on a risk factor that aims to get exposure to businesses with long-term business plans and competitive advantages. It can also be defined as the attributes for which investors are prepared to pay a premium (Hsu et al., 2019).

Academic research

The long-term outperformance of the quality factor over the market is well documented in the financial literature. Eugene Fama and Kenneth French added two quality-related components to their distinctive three-factor model (firm size, business value, and market risk): profitability and asset growth. Numerous active strategies have prioritized quality growth in their premium selection and portfolio construction processes. In 2012, Robert Novy-Marx published an essay proving that profitability and stability were just as useful as traditional value measures for assessing returns (MSCI Factor research, 2021).

Asness et al. (2018) propose a valuation model that illustrates how stock prices should increase if qualitative qualities such as profitability, growth, and safety improve. They demonstrate experimentally that high-quality stocks do fetch a premium on average, but not by a huge margin (Asness et al., 2018). Perhaps as a result of this perplexingly little influence of quality on price, high-quality stocks provide appealing risk-adjusted returns. Indeed, in the United States and 24 other countries, a factor that invests in high-quality companies and shorts low-quality companies generates significant risk-adjusted returns. The price of quality fluctuates throughout time, reaching a low point during the internet bubble, and a low price of quality suggests that QMJ will give a high rate of return in the future. Analysts’ price targets and earnings predictions indicate that systemic errors in return and earnings expectations are occurring as a result of quality issues (Asness et al., 2018).

MSCI Quality Factor Index

MSCI Factor Indexes are rule-based, transparent indexes that target equities with favorable factor qualities, as determined by academic discoveries and empirical outcomes, and are designed for easy implementation, replicability, and usage in both standard indexed and active portfolios. The MSCI Quality Factor Index measures the quality factor using three fundamental variables (MSCI Factor research, 2021) :

• Return on equity – a measure of a company in generating profits
• Debt to equity – a measure of a company’s leverage
• Earnings variability – a measure of how smooth earnings growth has been.

Quality is a “defensive” component, which means that it has historically benefited during periods of economic recession (MSCI Factor research, 2021). The quality factor has aided in explaining the performance of equities with low debt, steady profits, and a high profit margin.

Performance of the MSCI Quality Factor Index from

Figure 1 compares the MSCI Quality Factor Index’s performance to those of other factors from May 1999 to May 2020. All indices are rebalanced on a 100-point scale to ensure consistency in performance and to facilitate factor comparisons

Figure 1. Performance of the MSCI Quality Factor Index from 1999-2020.

Source: MSCI Factor research (2021).

The MSCI Quality Factor Index has traditionally outperformed the MSCI World Index in the long term, with a 1.98 percent annual return over the MSCI World Index since 1999, as seen below (MSCI Factor research, 2021).

Risk-return profile of MSCI Quality Factor Index

Figure 2 shows the MSCI Quality Factor Index compared to other factors over the period May 1999 – May 2020 in terms of risk/reward. The risk-return trade-off states that the potential return rises with an increase in risk. Individuals connect low levels of uncertainty about future returns with low potential returns, while high levels of uncertainty or risk are associated with large potential returns. According to the risk-return trade-off, an investor’s money can generate higher returns only if the investor is willing to endure a higher risk of loss as shown in Figure 2.

Figure 2. Risk-return profile of MSCI Yield Factor Index compared to a peer group.

Source: MSCI Factor research (2021).

Behavior of the MSCI Quality Factor Index during the Covid-19 crisis

The Covid-19 crisis has not only caused significant social and economic suffering, but it had also an impact on financial markets. To study the behavior of the factors during the Covid-19 crisis, we compute the return of the MSCI Factor indexes during the different stages of the crisis. The MSCI Factor indexes are: value, size, quality, momentum and minimum volatility. Following Pagano et al. (2020) and Hasaj and Sherer (2021), we decompose the Covid-19 crisis into five stages: origin, incubation, outbreak, fever, and treatment. Each stage is described below.

• Origin (01/11/2019 – 01/01/2020): the first instances are reported in Wuhan, China.
• Incubation (02/01/2020 – 17/01/2020): during this phase, the number of patients began to rise at a faster rate, raising concerns about the disease’s severity.
• Outbreak (20/01/2020 – 21/02/2020): the number of cases rose to the point that the World Health Organization (WHO) decided that this illness may pose a major threat to the world’s population, and the pandemic was proclaimed.
• Fever (24/02/2020 – 20/03/2020): markets are extremely volatile, owing to government restrictions aimed at flattening the infection curve, with the decision to impose a lockdown in numerous nations as the most notable measures, among others.
• Treatment (23/03/2020 – 15/04/2020): most of this turnaround occurs between March and June 2020, which corresponds with the start of good news about the discovery and widespread use of the vaccine.

Table 1 gives the performance of the MSCI factor indexes during the different stages of the Covid-19 crisis. Performance is measured by the return computed on the time-period of each stage, and then annualized for comparison across the different stages. We use data are from Thomson Reuters.

Table 1. Performance of the MSCI factor indexes during the Covid-19 crisis.

Source: computation by the author. Data source: Thomson Reuters.

A conclusive statement can be made based on our analysis. The quality component was the strongest performer throughout the COVID crisis’s inception in late 2020 and during the fever phase, when severe limitations were implemented, resulting in a collapsing market.

ETFs to capture the Quality factor

Let us recall that an Exchange-Traded Fund (ETF) is an investment vehicle that seeks to mirror the performance of a benchmark like an equity index and is traded on a continuous basis during the day like stocks. By investing in ETFs, an investor gains access to a plethora of diversification options through several asset classes (equity, bonds, currency, commodity, real estate, etc.).

Figure 3 illustrates the overall ETF distribution of the major providers of quality factor ETFs in terms of percentage of asset under management. By examining the market overview for quality factor investments, we can observe SPDR dominance in this factor investing market, with 76.07%, representing more than three quarters of the overall quality factor ETF market.

Figure 3. Quality factor ETF market.

Source: etf.com (2021).

Table 2 gives more detailed information about the biggest quality factor ETF providers: the asset under management (AUM), expense ratio (ER) and the segment for the investments.

Table 2. Ranking of the biggest Quality ETF providers.

Source: etf.com (2021).

Why should I be interested in this post?

If you are an undergraduate or graduate student at a business school or university, you may have encountered the CAPM in your 101 finance course. This post raises awareness of the presence of another market-priced risk factor.

If you are an investor, you may wish to consider increasing your exposure to the quality factor in order to boost your portfolio’s total return.

Related posts on the SimTrade blog

   ▶ Youssef LOURAOUI Minimum Volatility

   ▶ Youssef LOURAOUI Value Factor

   ▶ Youssef LOURAOUI Yield Factor

   ▶ Youssef LOURAOUI Momentum Factor

   ▶ Youssef LOURAOUI Size Factor

   ▶ Youssef LOURAOUI Growth Factor

Useful resources

Academic research

Clifford S. Asness & Andrea Frazzini & Lasse Heje Pedersen, 2019. “Quality minus junk,” Review of Accounting Studies, 24(1): 34-112.

Hasaj, M., Sherer, B., 2021. Covid-19 and Smart-Beta: A Case Study on the Role of Sectors. EDHEC-Risk Institute Working paper, 1-35.

Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.

Pagano, M., Wagner, C., Zechner, J., 2020. Disaster Resilience and Asset Prices, Working paper.

Business analysis

etf.com, 2021. Biggest Quality ETF providers.

MSCI Investment Research, 2021. Factor Focus: Quality.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Size Factor

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the size factor, which is based on a risk factor that aims to capture the documented outperformance of small-cap firms compared to larger enterprises.

This article is structured as follows: we begin by defining the size factor and reviewing academic studies. The MSCI Size Factor Index, which is well used as a benchmark in the asset management industry, is next presented in terms of performance, risk-return trade-off, and behavior during the Covid-19 crisis. We showcase the ETF market for investors looking to profit from the size factor.

Definition

In the world of investing, a factor is any aspect that helps explain an asset’s long-term risk and return performance. In the late 1970s, the portfolio management industry’s objective was to capture the market return on a portfolio. As a result of Markowitz and Tobin’s earlier research, William Sharpe, John Lintner, and Jan Mossin independently developed the Capital Asset Pricing Model (CAPM). Because it enabled investors to properly value assets in terms of systematic risk, the CAPM was a significant evolutionary step forward in the theory of capital market equilibrium (Mangram, 2013).

Eugene Fama and Kenneth French, following the CAPM’s original work, developed the Fama-French Three-Factor model in 1993 to solve the CAPM’s inadequacies. It claims that, in addition to the market risk component of the CAPM, two other factors have an effect on the returns on securities and portfolios: market capitalization (called the “size” factor) and the book-to-market ratio (referred to as the “value” factor). Other factor characteristics were developed to capture some additional performance as financial research advanced and significant contributions were made.

The Size factor has captured the long-run proclivity of small-cap firms to outperform larger enterprises. The work of Banz (1981) adds another piece to the growing puzzle. It evaluates the link between a firm’s overall market value and its return on common shares. The findings indicate that, on average, small businesses common stock generated greater risk-adjusted returns than large firms’ common stock throughout the 1936 – 1975 period (Banz, 1981). This impact is referred to as the “size effect”.

Academic research

Rolf Banz, a Ph.D. candidate at the University of Chicago at that time, found the size factor in US stocks in 1981. The size effect’s proponents provide many explanations for it. Banz stated that it is the result of a weakness in the capital asset pricing model (CAPM, the typical approach for forecasting risk and return on stock investments) or a lack of information regarding businesses that receive minimal analyst attention. After economists Eugene Fama and Kenneth French incorporated size as a critical component of their renowned three-factor model, size research exploded (MSCI Factor research, 2021).

Empirical studies

According to academic literature, the single-period capital asset pricing model (henceforth CAPM) postulates a straightforward linear connection between a security’s projected return and market risk. While direct testing has proved inconclusive, emerging evidence supports the possibility of other asset price variables.

For the period 1936-1977, Litzenberger and Ramaswamy (1979) demonstrate a substantial positive association between dividend yield and return on common stocks. Basu (1977) establishes a link between price-earnings ratios and risk-adjusted returns (Banz, 1981). He interprets his findings as evidence of market inefficiency; however, market efficiency tests are frequently conducted in conjunction with tests of the efficient market hypothesis and a particular equilibrium connection. Thus, some of the abnormalities ascribed to a lack of market efficiency may easily be the consequence of model misspecification. However, because the study’s findings are not based on a particular theoretical equilibrium model, it is impossible to clearly establish whether market value matters in and of itself or whether it is only a proxy for undiscovered actual extra elements linked with market value (Banz, 1981).

According to the data given in this paper, the CAPM is misspecified. Over a forty-year period, tiny NYSE businesses have generated considerably higher risk-adjusted returns than large NYSE enterprises (Banz, 1981). This size impact is not linear in market proportion (or market proportion log) but is most evident for the sample’s smallest companies. Additionally, the impact is not very stable over time. A comparison of the ten-year subperiods reveals significant variations in the magnitude of the size factor’s coefficient (Banz, 1981).

Such an impact has no theoretical basis. Banz asserts that we don’t even know if the factor is size itself or if size is only a proxy for one or more genuine but unknown factors that are linked with size (Banz, 1981). However, it is feasible to make certain hypotheses and even debate some aspects for which size is a proxy. Reinganum’s (1980) recent study has ruled out one obvious candidate: the price-earnings (P/E) ratios. He discovers that the P/E effect, as reported by Basu (1977), vanishes when he controls for size for both NYSE and AMEX stocks, but that there is a significant size effect even when he controls for the P/E ratio, implying that the P/E ratio effect is a proxy for the size effect and not the other way around (Banz, 1981).

Naturally, there are still a vast number of potential elements to evaluate. Thus, a lack of knowledge about small businesses results in less diversification and thus greater returns on ‘undesirable’ small business stocks (Banz, 1981). It may be tempting to use the size effect as the basis for a theory of mergers – big businesses may pay a premium for small firms’ shares because they can discount the same cash flows at a lower discount rate. Naturally, this may turn out to be total nonsense if it is demonstrated that size is only a proxy. While this informal model fits the empirical data, it is only speculation. The size effect occurs, but its cause is unknown. It should be regarded with caution until an answer is found (Banz, 1981).

MSCI Size Factor Index

MSCI Factor Indexes are rules-based, transparent indexes that target equities with favorable factor qualities, as determined by academic discoveries and empirical outcomes, and are designed for easy implementation, replicability, and usage in both standard indexed and active portfolios. The MSCI Equal Weighted Indexes tend to favor smaller cap firms. At each rebalance date, index components are weighted equally, thereby eliminating the influence of that constituent’s price (high or low) from the index. Size is a “pro-cyclical” element, which means it has historically benefited from periods of economic boom.

For decades, institutional investing has included a size premium. It has been a key component of several factor-based indexes during the last few years. MSCI Equal Weighted Indexes tend to favor smaller sized firms in comparison to the benchmark parent index (MSCI Factor research, 2021). At each rebalancing date, index components are weighted equally, thereby eliminating the influence of a constituent’s price (high or low) on the index.

Performance of the MSCI Size Factor Index

Figure 1 compares MSCI World Equal Weighted Index (Size factor) performance to those of other factors from May 1999 to May 2020. All indices are rebalanced on a 100-point scale to ensure consistency in performance and to facilitate factor comparisons.

Figure 1. Performance of the MSCI Size Factor Index from 1999-2020.

Source: MSCI Factor research (2021).

Over the long term, the MSCI World Equal Weighted Index (Size factor) has traditionally provided excess returns, with an annual return of 1.54 percent over the MSCI World Index since 1999 (MSCI Factor research, 2021).

Risk-return profile of MSCI Size Factor

Figure 2 shows the MSCI World Equal Weighted Index (Size factor) compared to other factors over the period May 1999 – May 2020 in terms of risk/reward. The risk-return trade-off states that the potential return rises with an increase in risk. Individuals connect low levels of uncertainty about future returns with low potential returns, while high levels of uncertainty or risk are associated with large potential returns. According to the risk-return trade-off, an investor’s money can generate higher returns only if the investor is willing to endure a higher risk (Figure 2).

Figure 2. Risk-return profile of MSCI Size Factor Index compared to a peer group.

Source: MSCI Factor research (2021).

Behavior of the MSCI Size Factor Index during the Covid-19 crisis

The Covid-19 crisis has not only caused significant social and economic suffering, but it had also an impact on financial markets. To study the behavior of the factors during the Covid-19 crisis, we compute the return of the MSCI Factor indexes during the different stages of the crisis. The MSCI Factor indexes are: value, size, quality, momentum and minimum volatility. Following Pagano et al. (2020) and Hasaj and Sherer (2021), we decompose the Covid-19 crisis into five stages: origin, incubation, outbreak, fever, and treatment. Each stage is described below.

• Origin (01/11/2019 – 01/01/2020): the first instances are reported in Wuhan, China.
• Incubation (02/01/2020 – 17/01/2020): during this phase, the number of patients began to rise at a faster rate, raising concerns about the disease’s severity.
• Outbreak (20/01/2020 – 21/02/2020): the number of cases rose to the point that the World Health Organization (WHO) decided that this illness may pose a major threat to the world’s population, and the pandemic was proclaimed.
• Fever (24/02/2020 – 20/03/2020): markets are extremely volatile, owing to government restrictions aimed at flattening the infection curve, with the decision to impose a lockdown in numerous nations as the most notable measures, among others.
• Treatment (23/03/2020 – 15/04/2020): most of this turnaround occurs between March and June 2020, which corresponds with the start of good news about the discovery and widespread use of the vaccine.

Table 1 gives the performance of the MSCI factor indexes during the different stages of the Covid-19 crisis. Performance is measured by the return computed on the time-period of each stage, and then annualized for comparison across the different stages. We use data are from Thomson Reuters.

Table 1. Performance of the MSCI factor indexes during the Covid-19 crisis.

Source: computation by the author. Data source: Thomson Reuters.

According to an examination of more than one year worth of market data, the size factor underperformed throughout the study period, most notably during the period of economic stress in the financial markets caused by the Covid-19 crisis. Given the crisis’s unprecedented severity, lockdown essentially shut down small and medium-sized firms, which finally suffered a period of catastrophic financial hardship, culminating in a non-negligible number of chain bankruptcies in the hardest-hit industries. This may help to explain why the Fever phase is the lowest-returning for the size factor. As the crisis progressed and governments spent billions on an accommodating monetary strategy to stimulate demand and re-establish healthy growth, size outperformed in the time after the pandemic’s fever phase (Figure 3).

ETFs to capture the Size factor

Let us recall that an Exchange-Traded Fund (ETF) is an investment vehicle that seeks to mirror the performance of a benchmark like an equity index and is traded on a continuous basis during the day like stocks. By investing in ETFs, an investor gains access to a plethora of diversification options through several asset classes (equity, bonds, currency, commodity, real estate, etc.).

Figure 3 illustrates the overall ETF distribution of the major providers of size factor ETFs in terms of percentage of asset under management. By examining the market overview for size factor investments, we can observe Blackrock and Vanguard dominance in this factor investing market, with 53.40% and 37.27% respectively, representing 90.67% of the overall size factor ETF market.

Figure 3. Size factor ETF market.

Source: etf.com (2021).

Table 2 gives more detailed information about the biggest size factor ETF providers: the asset under management (AUM), expense ratio (ER) and the segment for the investments.

Table 2. Ranking of the biggest Size ETF providers.

Source: etf.com (2021).

Why should I be interested in this post?

If you are an undergraduate or graduate student in a business school or at the university, you may have seen in your 101 finance course the CAPM related to the market factor. This post makes aware of the existence of another risk factor priced by the market.

If you are an investor, you may consider adding an exposure to size factor to enhance the overall portfolio return.

Related posts on the SimTrade blog

▶ Youssef LOURAOUI Minimum Volatility

▶ Youssef LOURAOUI Value Factor

▶ Youssef LOURAOUI Yield Factor

▶ Youssef LOURAOUI Momentum Factor

▶ Youssef LOURAOUI Quality Factor

▶ Youssef LOURAOUI Growth Factor

Useful resources

Academic research

Banz, R.W., 1981. The relationship between return and market value of common stocks. Journal of Financial Economics, 9: 3-18.

Basu, S., 1977. Investment performance of common stocks in relation to their price-earnings ratios: A test of Efficient Market Hypothesis. The Journal of Finance, 32: 663-682.

Fama, E.F., French, K.R. 1992. The Cross-Section of Expected Stock Returns. The Journal of Finance, 47: 427-465.

Fama, E.F., French, K.R., 2015. A five-factor asset pricing model. Journal of Financial Economics, 116(1): 1-22.

Hasaj, M., Sherer, B., 2021. Covid-19 and Smart-Beta: A Case Study on the Role of Sectors. EDHEC-Risk Institute Working paper.

Litzenberger, R., Ramaswamy, K., 1982. The Effects of Dividends on Common Stock Prices Tax Effects or Information Effects? The Journal of Finance, 37(2): 429-443.

Mangram, M.E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research, 7(1): 59-70.

Pagano, M., Wagner, C., Zechner, J., 2020. Disaster Resilience and Asset Prices, Working paper.

Reinganum, M., 1981. The Arbitrage Pricing Theory: Some Empirical Results. The Journal of Finance, 36(2): 313-321.

Business analysis

etf.com, 2021. Biggest Size Factor ETF providers.

MSCI Investment Research, 2021. Factor Focus: Size.

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).

Momentum Factor

In this article, Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021) presents the momentum factor, which is based on a risk factor that aims to get exposure to stocks that have a winning tendency in the upside and downside assuming that they will continue to do well in the short term.

Another similar concept related to momentum is trend following. It is a trading strategy that seeks to profit on an asset’s momentum in a certain direction. A trend occurs when the price moves in a consistent direction (upward or downward). Momentum investing and trading are based on the premise that prices respond to the strength of their supply and demand sources (at least in part) (Investopedia, 2021). It’s considered as a forward-looking strategy. Momentum manifests itself in a variety of different ways. It might be based on publicly traded firms’ earnings reports, the connection between buyers and sellers in the market, or even the usual pace of price rises and decreases in the past.

This article is structured as follows: we begin by defining the momentum factor and reviewing academic studies. The MSCI Momentum Factor Index, which is well used as a benchmark in the asset management industry, is next presented in terms of performance, risk-return trade-off, and behavior during the Covid-19 crisis. We showcase the ETF market for investors looking to profit from the momentum factor.

Definition

In the world of investing, a factor is any attribute that helps explain an asset’s long-term risk and return performance. In the late 1970s, the portfolio management industry’s objective was to capture the market return on a portfolio. As a result of Markowitz and Tobin’s earlier research, William Sharpe, John Lintner, and Jan Mossin independently developed the Capital Asset Pricing Model (CAPM). Because it enabled investors to properly value assets in terms of systematic risk, the CAPM was a significant evolutionary step forward in the theory of capital market equilibrium (Mangram, 2013).

Eugene Fama and Kenneth French, following the CAPM’s original work, developed the Fama-French three-factor model in 1993 to solve the CAPM’s inadequacies. It claims that, in addition to the market risk component of the CAPM, two other factors have an effect on the returns on securities and portfolios: market capitalization (called the “size” factor) and the book-to-market ratio (referred to as the “value” factor).
Other factor characteristics were developed to capture some additional performance as financial research advanced and significant contributions were made.

The Momentum factor refers to a winning stock’s tendency to continue doing well in the short term (Jegandeesh and Titman, 1993).

Academic research

The momentum premium was originally found by academics in 1993, when UCLA researchers Narasimhan Jegadeesh and Sheridan Titman proved that buying well-performing equities and selling underperforming ones provided large positive returns over three to twelve-month holding periods. The study finds that these techniques are profitable not because of their systematic risk or delayed stock price responsiveness to common causes. However, a portion of the anomalous returns achieved in the first year following portfolio creation fade away during the next two years. A similar pattern of returns is often observed around the earnings releases of previous winners and losers (Jegandeesh and Titman, 1993).

Empirical studies

Numerous subsequent research have established that the momentum factor exists across stock sectors, nations, and, more broadly, asset classes. Momentum is not as well understood as other variables, even though several theories seek to explain it. Some feel it is remuneration for taking on a high degree of risk, while others believe it is a result of market inefficiencies caused by delayed pricing reactions to firm-specific information.

While contrarian strategies have garnered much attention in recent academic research, the early work on market efficiency concentrated on relative strength strategies that invest in previous winners and sell past losers. Notably, Levy (1967) asserts that a trading method that purchases equities at prices significantly higher than their average price over the previous 27 weeks generates considerable anomalous profits. Jensen and Bennington (1970), on the other hand, note that Levy developed his trading rule after evaluating 68 alternative trading rules in his dissertation and express reservations about his results as a result (Jegandeesh and Titman, 1993). Jensen and Rennington examine the profitability of Levy’s trading rule over a lengthy period that falls mostly outside of Levy’s initial sample period. They discover that Levy’s trading rule does not outperform a buy and hold strategy throughout their sample period, and so ascribe Levy’s outcome to selection bias (Jegandeesh and Titman, 1993).

Economical interpretation

While the scholarly discussion has shifted away from relative strength trading rules, a lot of practitioners continue to utilize relative strength as a stock selection criterion. For example, Grinblatt and Titman (1989, 1991) found that most mutual funds purchased equities that had grown in price over the preceding quarter (Jegandeesh & Titman, 1993).

MSCI Momentum Factor Index

MSCI Factor Indexes are rules-based, transparent indexes that target equities with favorable factor qualities, as determined by academic discoveries and empirical outcomes, and are designed for easy implementation, replicability, and usage in both standard indexed and active portfolios. Momentum is classified as a “persistence” component, which means that it benefits from long-term market (MSCI Factor research, 2021). The MSCI Momentum Index measures:

• Risk-adjusted excess return – that is, return that surpasses the benchmark – during a 6-month period
• Risk-adjusted excess return that outperforms the benchmark over a 12-month period

These findings conclude in the research paper of Moskowitz et all (1999) hold up to a variety of criteria and treatments and provide critical practical insights into the profitability of momentum investing (Moskowitz, 1999). For example, these findings suggest that momentum strategies are not very well diversified, as both winners and losers typically come from the same industry. Additionally, if trading on momentum is desired, industry-based techniques tend to be more profitable and implementable. Unlike individual stock momentum techniques, which appear to be primarily driven by the sell side, industry momentum generates as much or more profit on the purchase side as on the sell side. Additionally, unlike individual stock momentum, sector momentum earnings continue to be robust among the largest, most liquid companies (Moskowitz, 1999).

Performance of the MSCI Momentum Factor Index

Figure 1 compares MSCI Momentum Factor Index performance to those of other factors from May 1999 to May 2020. All indices are rebalanced on a 100-point scale to ensure consistency in performance and to facilitate factor comparisons.

Figure 1. Performance of the MSCI Momentum Factor Index from 1999-2020.

Source: MSCI Factor research (2021).

According to MSCI research, the momentum component has historically been one of the most effective generators of excess returns, consistently excelling in macro conditions characterized by a prolonged cycle in underlying market trends. As per the figure below, the MSCI World Momentum Index has historically generated excess returns over the long run, outperforming the MSCI World Index by 3.17 percent year since 1999 (MSCI Factor study, 2021).

Risk-return profile of MSCI Momentum Factor Index

Figure 2 shows the MSCI Momentum Factor Index compared to other factors over the period May 1999 – May 2020 in terms of risk/reward. The risk-return tradeoff states that the potential return rises with an increase in risk. Individuals connect low levels of uncertainty about future returns with low potential returns, while high levels of uncertainty or risk are associated with large potential returns. According to the risk-tradeoff trade-off, an investor’s money can generate higher returns only if the investor is willing to endure a higher risk of loss (Figure 2).

Figure 2. Risk-return profile of MSCI Momentum Factor Index compared to a peer group.

Source: MSCI Factor research (2021).

Behavior of the MSCI Momentum Factor Index during the Covid-19 crisis

The Covid-19 crisis has not only caused significant social and economic suffering, but it had also an impact on financial markets. To study the behavior of the factors during the Covid-19 crisis, we compute the return of the MSCI Factor indexes during the different stages of the crisis. The MSCI Factor indexes are: value, size, quality, momentum and minimum volatility. Following Pagano et al. (2020) and Hasaj and Sherer (2021), we decompose the Covid-19 crisis into five stages: origin, incubation, outbreak, fever, and treatment. Each stage is described below.

• Origin (01/11/2019 – 01/01/2020): the first instances are reported in Wuhan, China.
• Incubation (02/01/2020 – 17/01/2020): during this phase, the number of patients began to rise at a faster rate, raising concerns about the disease’s severity.
• Outbreak (20/01/2020 – 21/02/2020): the number of cases rose to the point that the World Health Organization (WHO) decided that this illness may pose a major threat to the world’s population, and the pandemic was proclaimed.
• Fever (24/02/2020 – 20/03/2020): markets are extremely volatile, owing to government restrictions aimed at flattening the infection curve, with the decision to impose a lockdown in numerous nations as the most notable measures, among others.
• Treatment (23/03/2020 – 15/04/2020): most of this turnaround occurs between March and June 2020, which corresponds with the start of good news about the discovery and widespread use of the vaccine.

Table 1 gives the performance of the MSCI factor indexes during the different stages of the Covid-19 crisis. Performance is measured by the return computed on the time-period of each stage, and then annualized for comparison across the different stages. We use data are from Thomson Reuters.

Table 1. Performance of the MSCI factor indexes during the Covid-19 crisis.

Source: computation by the author (data source: Thomson Reuters).

Both during the pre-lockdown phase (January 2nd to January 17th 2020) and during the post-lockdown phase (23 March 2020 – 15 April 2021), the momentum component performed well, attaining the second best risk/reward tradeoff (Table 1).

ETFs to capture the Momentum factor

Let us recall that an Exchange-Traded Fund (ETF) is an investment vehicle that seeks to mirror the performance of a benchmark like an equity index and is traded on a continuous basis during the day like stocks. By investing in ETFs, an investor gains access to a plethora of diversification options through several asset classes (equity, bonds, currency, commodity, real estate, etc.).

Figure 3 illustrates the overall ETF distribution of the major providers of momentum factor ETFs in terms of percentage of asset under management. By examining the market overview for momentum factor investments, we can observe Blackrock’s dominance (iShares), with assets under management underpinning $27 billion of the overall market value, holding 55% of the overall percentage of the benchmark retained.

Figure 3. Momentum factor ETF market.

Source: etf.com (2021).

Table 2 gives more detailed information about the biggest momentum factor ETF providers: the asset under management (AUM), expense ratio (ER) and the segment for the investments.

Table 2. Ranking of the biggest Momentum ETF providers.

Source: etf.com (2021).

Why should I be interested in this post?

If you are an undergraduate or graduate student in a business school or at the university, you may have seen in your 101 finance course the CAPM related to the market factor. This post makes aware of the existence of an other risk factor priced by the market.

If you are an investor, you may consider adding an exposure to momentum factor to enhance the overall portfolio return.

Related posts on the SimTrade blog

   ▶ Youssef LOURAOUI Minimum Volatility

   ▶ Youssef LOURAOUI Value Factor

   ▶ Youssef LOURAOUI Yield Factor

   ▶ Youssef LOURAOUI Size Factor

   ▶ Youssef LOURAOUI Quality Factor

   ▶ Youssef LOURAOUI Growth Factor

Useful resources

Academic research

Fama, E.F. and French, K.R. (1992), The Cross-Section of Expected Stock Returns. The Journal of Finance , 47: 427-465.

Jegandeesh, N., Titman, S., 1993. Returns to buying winners and selling losers: Implication for stock market efficiency. The Journal of Finance , 48(1), 1-34.

Jensen, M. C., Benington, G. A. 1970. Random walks and technical theories: Some additional evidence. The Journal of Finance , 25: 469-482

Levy, R. A. 1967. Relative strength as a criterion for investment selection. The Journal of Finance , 22: 595-610.

Mangram, M. E., 2013. A simplified perspective of the Markowitz Portfolio Theory. Global Journal of Business Research , 7(1): 59-70.

Hasaj, M., Sherer, B., 2021. Covid-19 and Smart-Beta: A Case Study on the Role of Sectors. EDHEC-Risk Institute Working Paper, 1-35.

Pagano, M., Wagner, C., Zechner, J. 2020. Disaster Resilience and Asset Prices, Working paper.

Business analysis

etf.com, 2021. Biggest Momentum ETF providers.

MSCI Investment Research, 2021. Factor Focus: Momentum

Investopedia, 2021. The difference between Trends and Momentums

About the author

The article was written in September 2021 by Youssef LOURAOUI (ESSEC Business School, Global Bachelor of Business Administration, 2017-2021).