Stock Portfolio Return
Historically the performance of a portfolio was looked at and attributed in a fairly one dimensional fashion. Several positions would be combined into a portfolio and the resulting performance of the portfolio would be attributed to the performance of those positions.
Said another way, the entire performance of the portfolio was attributed to the skill of the investor in being able to choose the right positions.
Intuitively that make sense. However over time, technology and market understanding has improved which now allows us to increase the granularity of performance attribution. In other words, we are constantly improving the answer to the question of "Where are the returns for a specific portfolio really coming from?"
The first improvement on the above understanding of performance attribution was to realize that a portion of a stock portfolio's return comes from the market itself.
Any return over and above the return of the general market can be attributed to alpha (eg: investor skill). What this means is that if a portfolio has achieved a return of 24% over the last 3 years and the benchmark has achieved a return of 18% over the same period, the portfolio has in fact only outperformed the market by 6%.
It is not accurate to simply attribute the entire 24% return to portfolio performance or alpha while the benchmark (ie: market) return accounted for 18% of that. Portfolio return can therefore be divided as follows:
The next improvement in understanding portfolio return attribution is where factors and factor exposure comes in. Factors in a nutshell are specific characteristics or qualities that are used to explain where performance returns come from. Typically investors look for factors that have been shown to produce long term excess market returns.
A factor can be anything however there are typically 6 major factors which have historically accounted for the majority of returns in excess of the market. These factors are:
- Minimum Volatility - Involves choosing stocks based on their volatilities and correlations with other stocks.
- High Dividend Yield - Focuses on stocks that appear undervalued and have shown stable and increasing dividends.
- Quality - Focuses on stocks with durable business models and sustainable competitive advantages.
- Momentum - This factor refers to the tendency of the best performing stocks to continue showing strength going forward.
- Value - Stocks that are deemed to be value stocks are favoured.
- Size - The size factor captures the tendency for small cap stocks to outperform larger companies over the long run.
The above definitions simply provide an overview of each factor. For more detail on exactly how each factor is calculated you can refer here: Factor Indexes. However, the main takeaway is that the above 6 factors have been analyzed throughout academia and the professional investment world and have been shown to be drivers of excess market returns over the long term.
Next, with the understanding that certain factors exist and they produce excess market returns we are able to further divide portfolio returns as follows:
As can be seen in the above image, the alpha portion of a portfolios return actually consists of a factor exposure component.
Calculating Factor Exposure
Several statistical and analysis techniques are used in factor investing, the result of which is the ability to attribute the returns of a portfolio to market returns, factor exposures and lastly to alpha (ie: investor skill). One such method is by performing regression analysis on the historical returns of the portfolios excess market returns against the returns of the various factors.
To perform factor analysis on your portfolio, a tool such as this can be used: Factor Analysis Tool.
Practical Uses of Factor Analysis
The benefit of understanding factor investing and analysis is two fold:
- Smart beta investing - allocating capital to specific factor based ETF's or funds
- Generating alpha - understanding whether your portfolio has produced any real alpha over and above factor exposure
Smart Beta Investing
There are many ETF's and funds which are focused on specific factors. By investing in these factor ETF's, sometimes referred to as smart beta ETF's, you can increase or decrease your exposure to specific drivers of excess returns.
Certain factors are cyclical and may produce better returns at different times. You therefore have the option to take a more active approach to investing based on your expectations of the current business cycle and therefore which factors may produce better returns over the short to medium term. Alternatively a more passive approach can be taken by simply investing in multiple factor based ETF's.
By understanding your portfolios exposure to known factors you are able to determine whether or not your portfolio is producing any real alpha over and above simple exposure to known factors.
For example continuing with the above example of a portfolio that has produced 24% return, with 18% of that return being attributed to the market. This means that the remaining 6% return can be attributed to a combination of factor exposure and alpha (ie: investor skill).
If you perform factor analysis on the portfolio you may determine that of the 6% portion, 4% can be attributed to factor exposure. This means that even though you initially started out with a portfolio that achieved 24% return, once you've completed a thorough factor analysis to determine where those returns are actually coming from, you have only produced 2% of real alpha.
Because of this insight, you might decide that it makes more sense to therefore simply invest in smart beta ETF's rather than trying to pick and choose the best stocks or ETF's since it hasn't paid off nearly as much as you may have initially thought.
Another possibility to be aware of is that you might have actually produced zero or negative alpha. In essence this means that by trying to pick and choose the best stocks or by trying to time the market, you have actually ended up hurting your performance.
By understanding the percentage of real alpha that a portfolio has produced you are in a much better position to decide whether a more active or passive approach to your portfolio is warranted. Additionally you're able to decide whether increasing or decreasing specific factor exposures would be more favourable than trying to pick and choose specific stocks or ETF's.
It is important to understand where the returns of your portfolio coming from. Simply looking at a one dimensional view of your return leaves you with very little understanding of what is actually driving your performance.
By attributing portfolio performance to 3 components (market returns, factor exposure and alpha generation) you are in a much better position to increase or decrease exposure to those areas which are providing the most value.
To perform factor based analysis on your stock portfolio you can use the Factor Analysis Tool which will detail not only your portfolios current, but also your historical exposure to factors. The tool will also highlight whether or not your portfolio has produced alpha as a result of investor skill rather than simple exposure to known factors.
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