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