Factor based investing

Factor-based portfolio recommendations
PrimeSolve offers the ability to rank assets across your recommended product list taking into consideration the return factors which have historically demonstrated excess market returns over the long run. The factors covered are:

• Momentum
• Size
• Value
• Yield
• Quality

Each factor has a proven track record of outperformance.

PrimeSolve ranks each stock by each factor. A final score is arrived by overlaying a weighting to each factor type. You are able to adjust the factor weightings based on personal views. The default setting within PrimeSolve is as follows:

Momentum – Key principles
Academics first identified the momentum premium in 1993, when UCLA scholars Narasimhan Jegadeesh and Sheridan Titman demonstrated that the strategy of buying stocks that have done well and selling stocks that have done poorly generated significant positive returns over 3- to 12-month holding periods. Many studies since then have found the momentum factor present across equity sectors, countries, and more broadly asset classes.1 Momentum may not be as well understood as other factors, although various theories attempt to explain it. Some postulate that it is compensation for bearing high risk; others believe it may be a consequence of market inefficiencies produced by delayed price reactions to firm-specific information.2 MSCI research shows, on a historical basis, the momentum factor has been one of the strongest generators of excess returns.The momentum factor has typically outperformed in a macro environment characterized by a long cycle in underlying market trends (see chart Macro Effects on Factor Performance on p6).

How does PrimeSolve track momentum?
We track the 3 month, 6 month & 12 month excess market return (Sharp Ratio) and give each asset a total score based on the following:

Size – Key principles

University of Chicago Ph.D. Rolf Banz identified the size factor in U.S. stocks in 1981.3 Proponents of the size effect advance several explanations for it. Banz suggested that it stems from a flaw in the capital asset pricing model (CAPM, the standard method of projecting risk and return from stock investments) or from insufficient information about companies that get scant coverage by equity analysts. The research on size took off after economists Eugene Fama and Kenneth French included it as a key component in their influential three-factor model. Subsequent studies have found the persistence of the size effect across markets (see sources).

How does PrimeSolve track size factors?
We track the market capitalization of each stock and rank by size.

Value – Key principles

Many investors use this approach in identifying assets that they expect the market to revalue. The concept of value was first popularized in the 1930s by economists Benjamin Graham and David Dodd, who advocated owning companies that provide a “margin of safety” – meaning the current stock price is less than it is expected to be under conservative projections of the firm’s future earnings.4

How does PrimeSolve compare valuation?

PrimeSolve mirrors the approach taken by the MSCI Enhanced Value Index. The objective is to address some of the common pitfalls of value investing such as favoring stocks that appear cheap but may have little room for price appreciation. A value score is achieved by ranking companies on 3 factors:

Quality – Key principles

The long-term outperformance of the quality factor against the market is well documented in financial literature. Nobel laureates Eugene Fama and Kenneth French, economists known for their groundbreaking work in explaining stock returns, recently revised their signature three-factor model (company size, company value and market risk) to add two quality-related factors (profitability and asset growth). Many active strategies have emphasized quality growth as an important factor in their security selection and portfolio construction.5 In 2012, Robert Novy-Marx published a pioneering paper that found profitability and stability were just as useful for explaining returns as traditional value measures.6

How does PrimeSolve compare quality across companies?

PrimeSolve mirrors the approach taken by the MSCI Quality Index. The factors that we rank are as follows:

Yield – Key principles

Investors may focus on the equity dividend income that is associated with the yield factor for a variety of purposes. Institutional investors seeking income outside of the fixedincome world have used the strategy. For instance, an insurance company that needs a regular income stream to pay out claims could tilt its portfolio to the yield factor to meet this objective. High dividends have also historically accounted for a large portion of long-term total portfolio returns.7 Dividend investing is as old as stocks themselves, playing a central role in the evolution of corporations over the centuries. Groundbreaking economists Benjamin Graham and David Dodd famously called dividend payouts “the prime purpose of a business corporation … A successful company is one that can pay dividends regularly and presumably increase the rate as time goes on.” Several theories seek to explain the superior performance of high-dividend stocks. One notes that yield investors have preferred dividend payouts in the present to uncertain capital gains in the future.8 They have also tended to view dividend increases as a sign of future profitability. A number of studies show that dividend yields have been strong indicators of earnings growth.9

How does PrimeSolve compare yield across companies?

PrimeSolve seeks to avoid basic yield traps that arise from situations such as temporarily high earnings, high payout ratios, and falling stock prices. This is achieved in 2 steps.

Step 1: Allocate an initial score

An initial score is given to each stock based on the following criteria:

Once an initial score is determined we then apply any reduction factors to adjust the score for sustainability factors. The reduction factors are as follows:

1. Moskowitz, T.J. and M. Grinblatt. (1999). “Do Industries Explain Momentum?” Journal of Finance, Vol. 54, No. 4, pp. 1249–1290.
2. Jegadeesh, N. and S. Titman. (1993). “Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency.” Journal of Finance, Vol. 48, No. 1, pp. 65–91.
3. Banz, R.W. (1981). “The Relationship between Return and Market Value of Common Stocks.” Journal of Financial Economics, Vol. 9, No. 1, pp. 3-18.
4. Graham, B., D. Dodd, S. Cottle, R. Murray and F. Block. (1989). Graham and Dodd’s Security Analysis, McGraw-Hill.
5. Asness, C. S., A. Frazzini and L.H. Pederson, L. H. (2013). “Quality Minus Junk,” s.l.: Working Paper, AQR Capital Management.
6. Novy-Marx, R. (2012). “The Other Side of Value: The Gross Profitability Premium.” Journal of Financial Economics, Volume 108, pp. 1-28.
7. Wei Z., C. Chia and S. Katiyar. (2015).“Harvesting Equity Yield: Understanding Factor Investing.” MSCI Research Insight.
8. Lintner, J. (1956). “Distribution of Incomes of Corporations Among Dividends, Retained Earnings, and Taxes.” American Economic Review, Vol.46, pp. 97-113.
9. Arnott, R.D and C.S. Asness. (2003). “Surprise! Higher Dividends = Higher Earnings Growth.” Financial Analysts Journal, Vol.59, No.1, pp. 70-87.