RE­TURNS

Fac­tor premia rep­re­sent the ex­cess re­turns that are po­ten­tially avail­able from ex­po­sure to cer­tain fac­tors

Investment Executive - - FRONT PAGE - BY MICHAEL NAIRNE Michael Nairne, CFP, CFA, is pres­i­dent of Tacita Cap­i­tal Inc. of Toronto, a pri­vate fam­ily of­fice and in­vest­ment-coun­selling firm. The com­pany, its prin­ci­pals, em­ploy­ees and clients may own the se­cu­ri­ties men­tioned herein. IE

Some nar­row in­dices out­per­form the broader mar­ket.

to­day ’s low in­ter­est rates and high stock val­u­a­tions trans­late into mod­est ex­pected fu­ture re­turns. At a time of in­creas­ing longevity, this sit­u­a­tion cre­ates a for­mi­da­ble chal­lenge to fi­nan­cial ad­vi­sors as­sist­ing their clients in re­tire­ment plan­ning. Ad­vi­sors search­ing for means to po­ten­tially out­per­form the over­all stock mar­ket should ex­plore “fac­tor premia.”

A “fac­tor” is a com­mon char­ac­ter­is­tic of a group of se­cu­ri­ties that ex­plains their unique risk and re­turn pa­ram­e­ters. Fac­tor premia rep­re­sent the ex­cess re­turns that are po­ten­tially avail­able from ex­po­sure to cer­tain fac­tors. MSCI Inc. has iden­ti­fied six premia fac­tors for eq­ui­ties: high div­i­dend yield; low size; low volatil­ity; mo­men­tum; qual­ity; and value.

Glob­ally, the MSCI world high div­i­dend yield in­dex (HDYI), which fo­cuses on stocks with above-av­er­age div­i­dend yields and qual­ity char­ac­ter­is­tics, has out­per­formed the MSCI world in­dex (WI) by 1.7% an­nu­ally on av­er­age since De­cem­ber 1975. Stocks with high div­i­dend yields have been par­tic­u­larly at­trac­tive in Canada. Since Jan­uary 1999, the MSCI Canada HDYI has achieved a 3% an­nual pre­mium to the MSCI Canada in­dex (CI).

Low size, as mea­sured by the MSCI world small-cap in­dex (SCI), has out­per­formed the broad mar­ket by 4.1% an­nu­ally since Jan­uary 2001. Small com­pa­nies have been less re­ward­ing in Canada. The MSCI Canada SCI de­liv­ered an an­nual av­er­age re­turn of 1.5% more than the CI over the same pe­riod.

The MSCI world min­i­mum volatil­ity in­dex (MVI), which re­flects the per­for­mance of a min­i­mum vari­ance strat­egy, has out­per­formed the WI by 1% an­nu­ally since June 1988. In Canada, where en­ergy and re­sources stocks ex­ac­er­bate volatil­ity, the MSCI Canada MVI has achieved a pre­mium to the over­all mar­ket in Canada of 2.3% an­nu­ally on av­er­age since June 2001.

Stocks with high price mo­men­tum have achieved some of the rich­est fac­tor premia. The MSCI world mo­men­tum i ndex (MI) earned a 2.7% an­nual pre­mium since June 1973. In Canada, the MSCI Canada IMI MI out­per­formed the CI by an av­er­age of 4.9% a year since De­cem­ber 1998.

The MSCI world qual­ity in­dex (QI) has de­liv­ered an an­nual pre­mium of 1.3% vs the over­all mar­ket since De­cem­ber 1975, while the Canada QI out­per­formed the over­all mar­ket by 2.5% a year since De­cem­ber 1998.

De­spite the more re­cent chal­lenges of value stocks, the MSCI world value in­dex (VI) de­liv­ered a 1% pre­mium to the over­all mar­ket since Jan­uary 1975. Over the same pe­riod, the Canada VI out­per­formed by 1.1% per year on av­er­age.

There are two ex­pla­na­tions for the ex­cess re­turns from such fac­tors. One is that the higher re­turns rep­re­sent risk pre­mi­ums — com­pen­sa­tion for ad­di­tional risks be­yond that of the over­all stock mar­ket. For ex­am­ple, small-cap stocks are more volatile and less liq­uid than large-caps.

The sec­ond ex­pla­na­tion is from be­havioural fi­nance: in­vestors’ cog­ni­tive bias es, such as my­opia and over­con­fi­dence, lead to the per­sis­tent mis­pric­ing of cer­tain se­cu­ri­ties. For ex­am­ple, overly op­ti­mistic in­vestors over­es­ti­mate the earn­ings prospects of growth stocks while un­der­es­ti­mat­ing those of value stocks.

An ex­pand­ing ar­ray of ETFs in Canada and the U.S., as well as sev­eral low-cost quan­ti­ta­tive ac­tive port­fo­lio man­agers, pro­vide in­vest­ment strate­gies that pur­sue fac­tor premia.

One of two ex­pla­na­tions is that higher re­turns rep­re­sent risk pre­mi­ums

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