Question

Describe one of the factor styles (size, quality, low volatility, value, momentum) and why investors believe the factor has predictive power

Answer 1

Style factors are drivers of return within an asset class; they have historically delivered a return premium over the long term capturing a specific risk premium, behavioral anomaly, or structural market impediment. Examples include the well-known value, size, and momentum equity tilts.

A lower volatility means that a security's value does not fluctuate dramatically, but changes in value at a steady pace over a period of time.

Volatility gives certain information about the dispersion of returns around the mean, but gives equal weight to positive and negative deviations. Moreover, it completely leaves out extreme risk probabilities. Volatility is thus a very incomplete measure of risk.

Value

Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.

Size

Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.

Momentum

Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame

investors believe the factor has predictive power

One of the most important reasons for predicting the market’s movement is that several investors believe that the only time to invest in the market is when it is going up. When the market falls, such investors would like to stay away and return only when they are confident that the market would rise again. The recent rise in the popularity of SIPs is a welcome step in negating this belief, but it still very much exists..

While we as investors should certainly plan for our future, we should also stop hallucinating about our ability to accurately predict it. The world does not move the way we want it to, and it is surely in our interest to accept this fact, as early as possible.