Equity Styles Case Study

A thoughtfully chosen and constructed risk factor lens can provide transparency into what is driving the risks and returns of individual investments and portfolios. Venn, a powerful, factor-based analytics tool, can help investors uncover those drivers using the Two Sigma Factor Lens, which recently expanded to include equity style factors in addition to the existing macro risk factors.

In this case study, we demonstrate the Two Sigma Factor Lens’s functionality by using it to examine four different types of public funds: a smart beta manager, a traditional discretionary manager, a long/short equity manager, and a market neutral manager.

Introduction

Venn recently added five equity style factors – Value, Momentum, Small Cap, Quality, and Low Risk – to the Two Sigma Factor Lens. This marks an expansion from the “beta” component of the investment universe to the “risk premia” component. As a reminder, macro risk factors (such as Equity and Interest Rates) generally capture the primary risk and return drivers in institutional investor portfolios. Style factors (such as Value and Momentum) go a step further by identifying systematic, independent sources of risk within certain asset classes, like equities. When used together with the macro risk factors, the equity style factors can help explain more of the risk drivers across portfolios.

To demonstrate Venn’s functionality, we tested the updated Two Sigma Factor Lens by analyzing four different types of public funds:

1. A “smart-beta” fund manager, which we would expect to provide long equity market exposure while tilting toward certain equity style factors.
2. A traditional discretionary fund manager, which we would not expect to explicitly seek equity style factor exposure, but rather pick the stocks that the manager expects, in its discretion, will outperform the market.
3. A liquid alternative long/short equity fund, which we would expect to hedge (at least partially) equity market exposure while providing a diversifying source of return through exposure to equity style factors and/or alpha.
4. A liquid alternative market neutral fund, which we would expect to deliver returns that are uncorrelated to macro factors but that may exhibit exposure to style factors and/or alpha.

1. Smart Beta Example

The first fund we will analyze falls within the “smart beta” category. As mentioned before, smart beta managers typically provide long equity market exposure while also attempting to provide exposure to style factors, such as equity styles. We’ll take a look at the iShares Edge MSCI USA Momentum Factor ETF, which launched in Q2 2013 and has nearly $10 billion in assets under management.¹ The fund seeks to track the results of an index composed of U.S. large- and mid-capitalization stocks that exhibit relatively higher price momentum (as defined by MSCI as the trailing 6 and 12 month local price returns) compared to a traditional market capitalization-weighted parent index.² Therefore, we would expect this strategy to deliver exposure to the equity market as well as the Momentum equity style factor.

Let’s decompose the fund’s risks, measured by Venn, since its inception and measure its exposures using the Two Sigma Factor Lens:

Exhibit 1 shows that, according to Venn, the fund’s most significant positive factor exposures over this period were Equity and Momentum. The fund’s long equity market exposure to U.S. large and mid-cap stocks is reflected by the 0.84 beta to the Equity factor, and its tilting toward stocks with positive price appreciation resulted in a statistically meaningful beta of 0.20 to the Momentum equity style factor.

It’s interesting to note that this fund has negative, meaningful exposure to the Value equity style factor, as displayed in Exhibit 1. Per Venn, this negative exposure contributes almost the same amount of risk to the fund as Momentum, as presented in Exhibit 2. This result may be because Momentum and Value have demonstrated negative correlation historically.³ Stocks that have positive momentum in the recent past have appreciated in price and are therefore becoming more and more expensive relative to their starting point; thus less and less of a Value stock. Over the period of this analysis, the Value and Momentum style factors exhibited a -0.66 correlation. Therefore, during this time period, funds that were capturing positive Momentum may have experienced negative Value exposure and vice versa.

2. Traditional Discretionary Fund Example

The second fund we will analyze is managed by a traditional bottom-up equity manager that we would not expect to explicitly tilt toward systematic equity style factors. Instead, we would expect that this type of manager conducts extensive research on individual companies, scouring through financial statements, potentially meeting with management teams, and building models to evaluate future financial performance. Generally, we expect that they rely less on quantitative metrics than a systematic equity fund and apply more qualitative, discretionary principles in the stock selection process.

We’ll take a look at the Dodge & Cox Stock Fund, which has been around since 1965 and has garnered over $70 billion in assets.⁴ According to the fund’s principal investment strategy, the “fund typically invests in companies that, in Dodge & Cox’s opinion, appear to be temporarily undervalued by the stock market but have a favorable outlook for long-term growth.”⁵ We would expect the fund to deliver positive equity market exposure. However, we can also extract insight from the fund’s stated investment strategy. Selecting stocks that are “undervalued” could mean the fund exhibits Value exposure.

Let’s take a look at the fund’s exposures and risk decomposition:

The factor exposures calculated by Venn in Exhibit 3 reveal that, as expected, the fund’s largest factor exposure is to the Equity factor – it also drives a majority of the fund’s risk (shown in Exhibit 4). The next two most significant exposures are equity style factors: Small Cap and Value. Even though we would not expect Dodge & Cox to systematically invest in stocks with smaller market caps⁶ or with more attractive valuation ratios, the stocks that this fund may hold tend to exhibit these characteristics relative to the overall global equity market.

3. Liquid Alternative Long/Short Equity Example

The third fund we will analyze pursues a liquid alternative long-short equity strategy. Long-short equity funds seek to hedge (at least partially) their long exposure to the equity market by implementing short positions. Therefore, we would expect this group of funds to have a net exposure of less than 100% to the Equity factor.

As an example, we will analyze the Diamond Hill Long-Short Fund on Venn. The fund has been live for over 18 years and has collected over $4 billion in assets under management.⁷ The portfolio’s guidelines are to target around 40-60 long positions and around 20-40 short positions with target net market exposure (long exposure less short exposure) of approximately 40-75%.⁸ According to the fund’s factsheet, the objective is “to provide long-term capital appreciation by investing in companies selling for less than and shorting companies selling for more than our estimate of intrinsic value.”⁹ The fund’s investment strategy involves picking companies with “conservative balance sheets” and shorting the inverse.¹⁰ Even though we would not expect Diamond Hill to intentionally seek exposure to equity style factors, the investment process seems to select undervalued and high-quality stocks, which Venn would categorize as Value and Quality-oriented.

Let’s take a look at the factor analysis:

According to Venn, the fund’s Equity exposure is 0.63, which falls in the 0.4-0.75 range described above. The statistically significant Value exposure of 0.25 appears in addition to other equity style factors. Particularly noteworthy is the fund’s negative 0.27 exposure to Quality, which is contributing more than 2% to the fund’s risk over this time period (as displayed in Exhibit 6). As an investor, it could be useful to delve into what is causing the negative exposure, as the fund’s “conservative balance sheet” approach could be an aspect of Quality that is typically captured by leverage metrics. For example, all else equal, the less debt on a company’s balance sheet, the higher the quality of the company. As to the fund’s other factor exposures, perhaps its negative exposure to the Credit factor demonstrates the fund’s exposure to companies with low leverage, which can outperform during bad environments for credit.

Finally, it’s worth noting that, even though Venn has explained most of this fund’s risk, this fund has also experienced over 23% residual risk (as displayed in Exhibit 6). Residual risk represents risks not captured by the Two Sigma Factor Lens. Residual could be coming from a variety of sources, including sector tilts, investments outside the scope of the Two Sigma Factor Lens, and true manager skill in picking the best stocks to long and short.

4. Liquid Alternative Market Neutral Example

Finally, we will analyze a fund that pursues an alternative market neutral strategy. Market neutral funds seek to fully hedge their long exposure to market risks by implementing short positions. Therefore, we would expect this type of fund to exhibit a net exposure (long exposure less short exposure) of close to 0% to certain macro factors.

As an example, we will evaluate the Vanguard Market Neutral Fund, with over $1 billion in assets.¹¹ The fund employs a quantitative equity strategy that seeks to have low correlation to the broad equity market by investing in a diversified set of stocks on a market-neutral basis.¹² The fund’s goal, as stated on Vanguard’s website, is to “neutralize the effect of stock market movement on returns.”¹³ The fund’s prospectus sheds some insight into how the fund’s quantitative system ranks stocks to buy and sell, stating that Vanguard likes stocks that “it believes offer an appropriate balance between strong growth prospects and reasonable valuations”.¹⁴ Therefore, we would expect that the fund would have very low exposure to the Equity factor given the fund’s market neutrality objective and may exhibit exposures to Momentum (a growth-like factor) and Value.

Let’s take a look at the factor analysis:

Exhibit 7 indicates that the fund’s Equity exposure is -0.01, which is in line with our expectations. In fact, the only factors with statistically significant exposure are equity style factors, in particular Momentum, Value, and Quality. This could be a result of Vanguard’s quantitative system considering inputs such as recent price appreciation, strong growth prospects, and valuation and quality metrics when determining which stocks to buy and sell. An investor in this fund could use this analysis to ask the manager about the inputs to their systematic process and confirm that they match the empirical factor exposures.

Exhibit 8 indicates that Momentum is the factor that Venn indicates contributes most to the fund’s risk. Value is contributing negatively, meaning it is providing diversification, lowering the fund’s overall risk. This is likely because of the historical negative correlation between the Momentum and Value factors, as mentioned previously in the iShares Edge MSCI USA Momentum Factor ETF example. While the fund is shown to have statistically significant exposure to Quality in Exhibit 7, this factor does not appear to contribute meaningfully to the fund’s risk.

Finally, it’s worth noting that while this fund’s risk can be partly explained by the factors in the Two Sigma Factor Lens, it has also exhibited over 70% residual risk. Residual risk represents any risks not captured by the Two Sigma Factor Lens. As discussed earlier, this could be coming from a variety of sources, including sector tilts, investments outside the scope of the Two Sigma Factor Lens, and true manager skill.

Conclusion

A thoughtfully chosen and constructed risk lens can offer a framework and measurement tool to enhance allocation decisions in a portfolio. Specifically, using a factor lens can assist in the bottom-up manager selection process by estimating the separate idiosyncratic risks of a manager from identified macro or style factor risk. Determining how a manager is allocating risks can help investors understand what is unique about that manager and how the manager complements other managers in the investor’s overall portfolio.

A risk lens can also be helpful in evaluating the fees investors pay managers. Macro factors, such as Equity and Interest Rates, are cheap and easily accessible in global markets. Even equity style factors like Value and Momentum are becoming less expensive and investable with the advent of “smart beta” funds. If an investor has a manager that claims to provide positive, idiosyncratic returns and charges a high fee for that, it may be worthwhile to run their returns through a risk lens framework to determine if the investor is indeed receiving residual risk and return from that manager. If that manager is providing significant exposure to macro and equity style factors instead, it may be worth understanding that manager and the value they provide in greater detail.

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References

¹  Source: https://www.ishares.com/us/products/251614/ishares-msci-usa-momentum-factor-etf

²  Source: https://www.msci.com/documents/10199/f3a22268-affd-478a-b7a7-50dc90fad923

³  Source: Venn Factor Performance History

⁴ Source: Dodge & Cox Stock Fund Factsheet, September 30, 2018

⁵  Source: Dodge & Cox Stock Fund Factsheet, September 30, 2018

⁶  The fund is expected to invest in larger capitalization stocks because the fund is in the Large Blend Morningstar category and is benchmarked to the S&P 500 Index, a large capitalization equity index in the U.S

⁷  Source: https://www.diamond-hill.com/strategies/alternatives/mutual-funds/long-short/portfolio/

⁸  Source: https://www.diamond-hill.com/strategies/alternatives/mutual-funds/long-short/portfolio/

⁹   Source: https://www.diamond-hill.com/strategies/alternatives/mutual-funds/long-short/overview/. The fund’s prospectus objective is to provide long-term capital appreciation

¹⁰ Source: https://www.diamond-hill.com/strategies/alternatives/mutual-funds/long-short/overview/. The fund’s principal investment strategy, per the prospectus, involves “investing in U.S. equity securities of any size capitalization that Diamond Hill believes are undervalued and selling short equity securities of any size capitalization that Diamond Hill believes are overvalued

¹¹ Source: https://www.morningstar.com/funds/XNAS/VMNIX/quote.html

¹² Source: https://investor.vanguard.com/mutual-funds/profile/portfolio/vmnfx

¹³ Source: https://investor.vanguard.com/mutual-funds/profile/overview/vmnix. The fund’s prospectus objective is to provide long-term capital appreciation while limiting exposure to general stock market risk

¹⁴ The fund’s prospectus states “To implement the strategy, the advisor buys securities that it believes offer an appropriate balance between strong growth prospects and reasonable valuations relative to their industry peers and sells short securities that it considers to be overvalued, in amounts that it believes will achieve market neutrality.”

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