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Portfolio Factor Analysis

By analyzing your stock portfolio through the lens of Factor Contributions, you gain a deeper level of insight into where your returns are really coming from and whether or not you should increase exposure to specific Factors. This article explains how you can use Factor Analysis to improve the performance of your own portfolio.

What is Portfolio Factor Analysis

If you are completely new to the concept of smart beta or factor investing, we suggest you read through our prior article on this subject which will introduce the concept to you before continuing with this one which builds on the information discussed previously:

To summarize the above article briefly, portfolio returns can broadly be divided into 3 components:

  • The market - those returns attributed to the general market
  • Factor contributions - those returns attributed to well defined and broadly known risk / return factors
  • Alpha - those returns attributed to investor skill, market timing, stock selection etc

Investors (and portfolio managers) are always looking to maximize the alpha they produce for themselves or their clients. However with the advent of Factor Analysis (or smart beta), it has become clear that large parts of portfolio returns that were historically believed to be attributed to alpha can in fact be explained simply by exposure to common Factors.

Investing Directly in Factors

As we know from the prior article, Factors can be anything but are typically qualities or characteristics that have historically been shown to produce market beating returns. For example, Momentum and Value are two such Factors which have produced excess market returns over the long term.

Once a Factor has been discovered it is often possible to invest directly in that Factor. In other words instead of trying to find individual stocks which have shown strong Momentum and which you believe will produce market beating returns going forward, you are able to rather invest directly in an ETF that replicates the Momentum Factor.

There is no need to try to time the market or worry about selecting individual stocks if your goal is to gain exposure to specific Factors that have been shown to produce excess market returns.

Are your efforts being rewarded?

In addition to simply investing directly in Factor ETF's, it also pays to analyze your portfolio's Factor contributions. Investing directly in individual stocks takes a lot of time, skill, dedication, exposure to unsystematic risk and increased transaction costs. It is also far more difficult to produce real alpha (over and above the market and Factor returns) than what most people realize.

With this in mind you should understand whether or not your portfolio is producing any real alpha. In other words, is the time and effort you spend selecting individual stocks for your portfolio really producing market (and Factor) beating returns.

Today, getting exposure to the entire market is incredibly simple, all you need to do is invest in your choice of broad market focused ETF eg: $SPY. Similarly it is just as easy to get exposure to known Factors which produce market beating returns. Once again, there are ETF's specifically designed for this purpose.

Therefore, if you are going to spend the time, additional transaction costs and increased exposure to unsystematic risk required when picking individual stocks, you really have to understand if you are producing any real alpha to pay you for your efforts.

Analyzing your Portfolio's Factor Contributions

With the right tools, you can analyze your portfolio to determine whether or not you are producing any real alpha. In other words, is there any real investor skill, market timing or stock selection aspect to your portfolio that is outperforming both the general market and exposure to common Factors.

To illustrate how this can be done we ran an example portfolio consisting of 10 individual stocks through the Factor Analysis Tool over a time period of 5 years. During this time the portfolio achieved a 75.95% return. Just looking at this 75.95% return value gives you very little information, so lets dig a little deeper.

The first step is knowing how our benchmark performed over the same time period. Typically you would choose a broad market ETF to be your benchmark, however anything can be chosen based on your portfolio construction and objectives. In this case our benchmark achieved 64.55% which means the portfolio only beat the benchmark by 11.4%.

portfolio versus benchmark return

If we were to stop there we might be happy to have outperformed the market, however we still don't have the entire picture. Next, we need to determine how much of that 11.4% is actually due to skill (alpha) and how much is due to simple Factor exposure.

factor marginal contribution to active risk

The above chart shows the portfolio's rolling 90 day marginal contributions to active risk. The analysis was performed against 6 Factors which have been analyzed throughout academia and the professional investment world and have been shown to produce excess market returns.

Just by eye balling the results, it appears that the Momentum Factor was generally the largest positive contributor to our returns. Lastly, let's have a look at the actual percentage contributions for each Factor and any alpha component.

portfolio factor percentages

As we suspected, the Momentum Factor was the biggest contributor to our returns. Each of the other major Factors contributed somewhere around 1% to 1.7%.

Now we finally get to the answer we've been looking for. Has this portfolio produced any real alpha? Have we shown any real investor skill, market timing or stock selection acumen in this portfolio?

Sitting at the bottom of the second column is the alpha contribution of 0.54%. Not very impressive. We started out feeling quite good having a portfolio that returned 75.95%, however after performing a complete Factor Analysis on the portfolio over the last 5 years we have determined that only 0.54% of that return has anything to do with skill. Everything else can be attributed to the broad market and known investment Factors.

factor analysis table

How does this information help us?

Now that we have this information, how does it help us. As mentioned, trying to pick the right individual stocks for a portfolio is extremely difficult and exposes you not only to the unsystematic risks associated with those companies but to all the risks related to market timing and personal biases.

If you are going to spend the time and effort trying to pick and choose the right stocks, you want to know that you are being paid to do so and that you are outperforming other arguably lower risk approaches.

In the case of the above example we determined that trying to choose individual stocks actually didn't help us at all. There was nothing in our stock selection process that outperformed the broad market and the known Factors.

A far better approach would have been to simply buy a broad market ETF along with a few specific Factor (smart beta) ETFs and be done with it.

Combining Factor Investing and Stock Selection

There are many ways to incorporate Factor Analysis into your investing:

  1. One way is to simply invest in specific Factor ETF's and be done with it. This approach reduces transaction costs, time, effort and unsystematic risk.

  2. Another way is to perform regular Factor Analysis against your stock portfolio to make sure that you are actually producing real alpha. If you determine that you are in fact outperforming the market and known market beating Factors, then you can count yourself among an elite few.

  3. A final way to incorporate Factor Analysis into your portfolio is to divide your capital into 2 parts. The first part is used to invest directly in Factor based ETF's. The second part is used to invest in individual stocks.


    On a regular basis you perform Factor Analysis against the individual stock portion of your portfolio. Based on the results you then either increase or decrease the capital you assign to that part of your portfolio.


    For example if you find that you are consistently producing real alpha, then you allocate 60% of your funds to individual stocks and 40% to Factor based ETF's. On a regular basis, repeat the Factor Analysis and adjust your asset allocations accordingly.

Summary

Investing in the stock market can be incredibly profitable however you need to ensure you understand the risk, return, asset allocation and diversification characteristics of your portfolio. Simply looking at your returns or a basic broker statement at the end of each month, quarter or year is not good enough.

Factor Analysis provides you with a deeper level of insight into where your returns are coming from and whether or not you are beating the market. If you are not beating the market then you are taking on a lot of unnecessary risk for none of the reward.

Just because your portfolio is up on the year, doesn't mean there was any real alpha produced. In fact you may find that your alpha was negative and the only reason your portfolio has a positive return is because of its exposure to common Factors. If that is the case, it may be prudent to allocate part of your capital to Factor based ETF's.

To analyze your portfolios exposure to common Factors, the Factor Analysis Tool can be used.

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