A common Venn use case is reviewing a manager’s factor analysis output to try and better understand their style and approach. Sometimes the output can help confirm one’s understanding of what the manager is doing, and other times it can lead to questions for the manager. An example of the latter case may be a manager that purports to invest in stocks based on value characteristics, but factor analysis output indicates a zero or negative “Value” factor exposure. This would be unexpected based on the mandate, so an investor might want to better understand what’s driving that result.
At an aggregate level, we were curious as to how often unexpected factor exposures may occur in mutual funds based on the stated style or strategy of a manager. So we analyzed the factor exposures of substantially all funds within four U.S. open-ended Morningstar categories: Large Growth, Large Value, Small Growth, and Small Value.1 In this post, we explore each category in turn, comparing our guesses for their Value and Small Cap factor exposures to their actual factor analysis results. As you’ll see below, a number of funds appeared to either have unexpected factor exposures or might belong to the wrong Morningstar category to begin with.
Large Growth
To start, we’ll look at funds in the Large Growth category. The funds in this category “invest primarily in big U.S. companies that are projected to grow faster than other large-cap stocks,” according to the Morningstar category definition.2 Growth is defined as companies that exhibit high growth rates (in areas like earnings and sales) and high valuations.3
Based on this, we expect the Large Growth category to exhibit negative exposure to Venn’s Value factor, which is defined partly by companies that have low valuations (for example, low price-to-book is a key metric for Venn’s Value factor). Additionally, we expect the category to exhibit close to zero or even slightly negative exposure to Venn’s Small Cap factor (the single metric for this factor is market capitalization), as funds in the Large Growth category should be investing in large cap stocks.
As displayed in Exhibit 1, the average exposures (as indicated by the “x” in the box and whisker chart) to Venn’s Value and Small Cap factors were negative and positive respectively. Value largely met our expectations, although there were some funds in the category that exhibited positive exposure to the factor, with the maximum factor beta around +0.2.
The positive average Small Cap factor exposure was unexpected. There were quite a few funds in the category that exhibited fairly high positive exposure to the Small Cap factor, despite being in a large cap category.
Exhibit 1: Value and Small Cap Factor Exposures for Funds in the Large Growth Category
Source: Venn. Time Period: October 29, 2016 - October 28, 2019. Analysis run using the USD version of the Two Sigma Factor Lens.
Large Value
Next, we’ll look at funds in the Large Value category. Value is defined by Morningstar as effectively the opposite of Growth; companies with low valuations and slow growth.4 Therefore, our expectation is that the category’s factor exposure to Venn’s Value factor will be positive. And we predict Small Cap exposure to be zero to slightly negative for the same reasons as Large Growth - we expect that these funds are investing in large cap stocks.
Exhibit 2 displays the Venn factor analysis results for the Large Value category. According to Venn, the average positive exposure for Value was in line with our expectations, although, to our surprise, there was one outlier fund that exhibited negative Value exposure.
In terms of the Small Cap exposure, results were similar to that in the Large Growth category. There were several funds that exhibited zero or negative Small Cap exposure, but a majority actually exhibited positive Small Cap exposure. Again, funds in this category are supposedly invested in large cap stocks, so it was unexpected that so many would have positive Small Cap factor exposure.
Exhibit 2: Value and Small Cap Factor Exposures for Funds in the Large Value Category
Source: Venn. Time Period: October 29, 2016 - October 28, 2019. Analysis run using the USD version of the Two Sigma Factor Lens.
Small Growth
We’ll now switch our attention to the small cap categories, starting with Small Growth. Morningstar defines this category as funds that “focus on faster-growing companies whose shares are at the lower end of the market-capitalization range.”5 Growth is defined in the same way as the Large Growth category (i.e. funds investing in companies with high growth rates and high valuations). Therefore, our expectations for the Small Growth category would be positive exposure to Venn’s Small Cap factor and negative exposure to Venn’s Value factor.
Exhibit 3 shows that most of the funds in the Small Growth category exhibited negative or zero Value factor exposure, as expected. Surprisingly though, quite a few funds had a positive Value exposure despite being in a growth category.
The Small Cap exposure, on the other hand, was very much in line with expectations. All funds, with the exception of one outlier, exhibited positive, and in most cases high, Small Cap factor exposure.
Exhibit 3: Value and Small Cap Factor Exposures for Funds in the Small Growth Category
Source: Venn. Time Period: October 29, 2016 - October 28, 2019. Analysis run using the USD version of the Two Sigma Factor Lens.
Small Value
Finally, we’ll analyze funds in the Small Value category. These funds are expected to invest in small cap companies that have low valuations and slow growth rates, per the explanations provided above for the other categories. Based on this, we expect these funds to deliver positive exposure to Venn’s Value and Small Cap factors.
We end on a positive note. Exhibit 4 shows that funds in the Small Value category met our expectations for both their Value and Small Cap factor exposures. In fact, not only did the average exposure to both factors appear positive, but there wasn’t one fund that exhibited negative exposure to either factor.
Exhibit 4: Value and Small Cap Factor Exposures for Funds in the Small Value Category
Source: Venn. Time Period: October 29, 2016 - October 28, 2019. Analysis run using the USD version of the Two Sigma Factor Lens.
Concluding Thoughts
We believe that factor analysis can be an effective tool for understanding a manager’s strategy. We analyzed funds in four of Morningstar’s mutual fund categories and compared their expected exposures to actual factor exposures according to Venn.
There appears to be a meaningful number of funds that have unexpected Value and Small Cap exposures relative to what their Morningstar categories would suggest. The most frequent “culprits” are funds in large cap categories that exhibit positive Small Cap exposures. Here are some hypotheses for why this might be happening:
- This could be a result of funds dipping lower in the market capitalization spectrum, perhaps in an attempt to achieve higher returns to outperform their large cap benchmarks.
- There could be differences in the way Morningstar defines value, growth, small cap, and large cap versus how fund practitioners measure these factors.
- There might also be differences with the way we designed the factors in the Two Sigma Factor Lens, namely for Small Cap since that factor is showing up frequently in funds that are categorized as large cap. To test this, we looked at the S&P 500 Index’s factor analysis results. We knew before the fact that this is a large cap focused equity index that shouldn’t have Small Cap factor exposure. As shown in Exhibit 5, there was no Small Cap exposure indicated -- just Equity and Local Equity, as expected.
Exhibit 5: S&P 500 Index Factor Exposures
Source: Venn. Time Period: October 29, 2016 - October 28, 2019. Analysis run using the USD version of the Two Sigma Factor Lens.
- It could be the case that certain funds belonged to the wrong Morningstar category to begin with.
- Perhaps certain funds started off in the appropriate Morningstar category but have since drifted into other categories.
REFERENCES
1 Sources: Venn, Morningstar. The factor analysis used the USD version of the Two Sigma Factor Lens for the three year period October 29, 2016 - October 28, 2019 using daily data. Funds were excluded if they did not have returns for the full period.
2 Source: The Morningstar Category Classifications as of April 29, 2016.
3 Source: The Morningstar Category Classifications as of April 29, 2016.
4 Source: The Morningstar Category Classifications as of April 29, 2016.
5 Source: The Morningstar Category Classifications as of April 29, 2016.
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