To generate returns that are different than the market, we must adopt a positioning that is different than the market.
With the increasing adoption of systematic factor portfolios, we explore whether an anti-factor stance can generate contrarian-based profits.
Specifically, we explore the idea of factor orphans: stocks that are not included in any factor portfolio at a given time.
To identify these stocks, we replicate four popular factor indices: the S&P 500 Enhanced Value index, the S&P 500 Momentum index, the S&P 500 Low Volatility index, and the S&P 500 Quality index.
On average, there are over 200 stocks in the S&P 500 that are orphaned at any given time.
Generating an equal-weight portfolio of these stocks does not exhibit meaningfully different performance than a naïve equal-weight S&P 500 portfolio.
Contrarian investing is nothing new. Holding a variant perception to the market is often cited as a critical component to generating differentiated performance. The question in the details is, however, “contrarian to what?”
In the last decade, we’ve witnessed a dramatic rise in the popularity of systematically managed active strategies. These so-called “smart beta” portfolios seek to harvest documented risk premia and market anomalies and implement them with ruthless discipline.
But when massively adopted, do these strategies become the commonly-held view and therefore more efficiently priced into the market? Would this mean that the variant perception would actually be buying those securities totally ignored by these strategies?
This is by no means a new idea. Morningstar has long maintained its Unloved strategy that purchases the three equity categories that have witnessed the largest outflows at the end of the year. A few years ago, Vincent Deluard constructed a “DUMB” beta portfolio that included all the stocks shunned by popular factor ETFs. In the short out-of-sample period the performance of the strategy was tested, it largely kept pace with an equal-factor portfolio. More recently, a Bank of America research note claimed that a basket of most-hated securities – as defined by companies neglected by mutual funds and shorted by hedge funds hedge funds – had tripled the S&P 500’s return over the past year.
The approach certainly has an appealing narrative: as the crowd zigs to adopt smart beta, we zag. But has it worked?
To test this concept, we wanted to identify what we call “factor orphans”: those securities not held by any factor portfolio. Once identified, we can build a portfolio holding these stocks and track its performance over time.
As a quant, this idea strikes us as a little crazy. A stock not held in a value, momentum, low volatility, or quality index is likely one that is expensive, highly volatile, with poor fundamentals and declining performance. Precisely the type of stock factor investing would tell us not to own.
But perhaps the fact that these securities are orphaned means that there are no more sellers: the major cross-section of market strategies have already abandoned the stock. Thus, stepping in to buy them may allow us to offload them later when they are picked back up by these systematic approaches.
Perhaps this idea is crazy enough it just might work…
To test this idea, we first sought to replicate four common factor benchmarks: the S&P 500 Enhanced Value index, the S&P 500 Momentum index, the S&P 500 Low Volatility index and the S&P 500 Quality index. Once replicated, we can use the underlying baskets as being representative of the holdings for factor portfolios is general.
Results of our replication efforts are plotted below. We can see that our models fit the shape of most of the indices closely, with very close fits for the Momentum and Low Volatility portfolios.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
The Quality replication represents the largest deviation from the underlying index, but still approximates the shape of the total return profile rather closely. This gives us confidence that the portfolio we constructed is a quality portfolio (which should come as no surprise, as securities were selected based upon common quality metrics), but the failure to more closely replicate this index may represent a thorn in our ability to identify truly orphaned stocks.
At the end of each month, we identify the set of all securities held by any of the four portfolios. The securities in the S&P 500 (at that point in time) but not in the factor basket are the orphaned stocks. Somewhat surprisingly, we find that approximately 200 names are orphaned at any given time, with the number reaching as high as 300 during periods when underlying factors converge.
Also interesting is that the actual overlap in holdings in the factor portfolios is quite low, rarely exceeding 30%. This is likely due to the rather concentrated nature of the indices selected, which hold only 100 stocks at a given time.
Source: Sharadar. Calculations by Newfound Research.
Once our orphaned stocks are identified, we construct a portfolio that holds them in equal weight. We rebalance our portfolio monthly to sell those stocks that have been acquired by a factor portfolio and roll into those securities that have been abandoned.
We plot the results of our exercise below as well as an equally weighted S&P 500 benchmark.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
While the total return is modestly less (but certainly not statistically significantly so), what is most striking is how little deviation there is in the orphaned stock portfolio versus the equal-weight benchmark.
However, as we have demonstrated in the past, the construction choices in a portfolio can have a significant impact upon the realized results. As we look at the factor portfolios themselves, we must acknowledge that they represent relative tilts to the benchmark, and that the absence of one security might actually represent a significantly smaller relative underweight to the benchmark than the absence of another. Or the absence of one security may actually represent a smaller relative underweight than another that is actually included.
Therefore, as an alternative test we construct an equal-weight factor portfolio and subtract the S&P 500 market-capitalization weights. The result is the implied over- and under-weights of the combined factor portfolios. We then rank securities to select the 100 most under-weight securities each month and hold them in equal weight.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
Of course, we didn’t actually have to perform this exercise had we stepped back to think for a moment. We generally know that these (backtested) factors have out-performed the benchmark. Therefore, selecting stocks that they are underweight means we’re taking the opposite side of the factor trade, which we know has not worked.
Which does draw an important distinction between most underweight and orphaned. It would appear that factor orphans do not necessarily create the strong anti-factor tilt the way that the most underweight portfolio does.
For the sake of completion, we can also evaluate the portfolios containing securities held in just one of the factor portfolios, two of the factor portfolios, three of the factor portfolios, or all of the factor portfolios at a given time.
Below we plot the count of securities in such portfolios over time. We can see that it is very uncommon to identify securities that are simultaneously held by all the factors, or even three of the factors, at once.
Source: Sharadar. Calculations by Newfound Research.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
We can see that the portfolio built from stocks held in just one factor (“In One”) closely mimics the portfolio built from stocks held in no factor (“In Zero”), which in turn mimics the S&P 500 Equal Weight portfolio. This is likely because the portfolios include so many securities that they effectively bring you back to the index.
On the other end of the spectrum, we see the considerable risks of concentration manifest in the portfolios built from stocks held in three or four of the factors. The portfolio comprised of stocks held in all four factors simultaneously (“In Four”) not only goes long stretches of holding nothing at all, but is also subject to large bouts of volatility due to the extreme concentration.
We also see this for the portfolio that holds stocks held by three of the factors simultaneously (“In Three”). While this portfolio has modestly more diversification – and even appears to out-perform the equal-weight benchmark – the concentration risk finally materializes in 2018-2019, causing a dramatic drawdown.
The portfolio holding stocks held in just two of the factors (“In Two”), though, appears to offer some out-performance opportunity. Perhaps by forcing just two factors to agree, we strike a balance between confirmation among signals and portfolio diversification.
Unfortunately, our enthusiasm quickly wanes when we realize that this portfolio closely matches the results achieved just by naively equally-weighting exposure among the four factor portfolios themselves, which is far more easily implemented.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
Conclusion
To achieve differentiated results, we must take a differentiated stance from the market. As systematic factor portfolios are more broadly adopted, we should consider asking ourselves if taking an anti-factor stance might lead to contrarian-based profits.
In this study, we explore the idea of factor orphans: stocks not held by any factor portfolio at a given time. Our hypothesis is that these orphaned securities may be systematically over-sold, leading to an opportunity for future out-performance if they are re-acquired by the factor portfolios at a later date.
We begin by replicating four factor indices: the S&P 500 Enhanced Value index, the S&P 500 Momentum index, the S&P 500 Low Volatility index, and the S&P 500 Quality index. Replicating these processes allows us to identify historical portfolio holdings, which in turn allows us to identify stocks not held by the factors.
We are able to closely replicate the S&P 500 Momentum and Low Volatility portfolios, create meaningful overlap with the S&P 500 Enhanced Value method, and generally capture the S&P 500 Quality index. The failure to more closely replicate the S&P 500 Quality index may have a meaningful impact on the results herein, though we believe our methodology still captures the generic return of a quality strategy.
We find that, on average, there are over 200 factor orphans at a given time. Constructing an equal-weight portfolio of these orphans, however, only seems to lead us back to an S&P 500 Equal Weight benchmark. While there does not appear to be an edge in this strategy, it is interesting that there does not appear to be a negative edge either.
Recognizing that long-only factor portfolios represent active bets expressed as over- and underweights relative to the S&P 500, we also construct a portfolio of the most underweight stocks. Not surprisingly, as this portfolio actively captures a negative factor tilt, the strategy meaningfully underperforms the S&P 500 Equal Weight benchmark. Though the relative underperformance meaningfully dissipates in recent years.
Finally, we develop portfolios to capture stocks held in just one, two, three, or all four of the factors simultaneously. We find the portfolios comprised stocks held in either three or four of the factors at once exhibit significant concentration risk. As with the orphan portfolio, the portfolio of stocks held by just one of the factors closely tracks the S&P 500 Equal Weight benchmark, suggesting that it might be over-diversified.
The portfolio holding stocks held by just two factors at a time appears to be the Goldilocks portfolio, with enough concentration to be differentiated from the benchmark but not so much as to create significant concentration risk.
Unfortunately, this portfolio also almost perfectly replicates a naïve equal-weight portfolio among the four factors, suggesting that the approach is likely a wasted effort.
In conclusion, we find no evidence that factor orphans have historically offered a meaningful excess return opportunity. Nor, however, do they appear to have been a drag on portfolio returns either. We should acknowledge, however, that the adoption of factor portfolios accelerated rapidly after the Great Financial Crisis, and that backtests may not capture current market dynamics. More recent event studies of orphaned stocks being added to factor portfolios may provide more insight into the current environment.
Factor Orphans
By Corey Hoffstein
On October 28, 2019
In Risk & Style Premia, Weekly Commentary
This post is available as a PDF download here.
Summary
Contrarian investing is nothing new. Holding a variant perception to the market is often cited as a critical component to generating differentiated performance. The question in the details is, however, “contrarian to what?”
In the last decade, we’ve witnessed a dramatic rise in the popularity of systematically managed active strategies. These so-called “smart beta” portfolios seek to harvest documented risk premia and market anomalies and implement them with ruthless discipline.
But when massively adopted, do these strategies become the commonly-held view and therefore more efficiently priced into the market? Would this mean that the variant perception would actually be buying those securities totally ignored by these strategies?
This is by no means a new idea. Morningstar has long maintained its Unloved strategy that purchases the three equity categories that have witnessed the largest outflows at the end of the year. A few years ago, Vincent Deluard constructed a “DUMB” beta portfolio that included all the stocks shunned by popular factor ETFs. In the short out-of-sample period the performance of the strategy was tested, it largely kept pace with an equal-factor portfolio. More recently, a Bank of America research note claimed that a basket of most-hated securities – as defined by companies neglected by mutual funds and shorted by hedge funds hedge funds – had tripled the S&P 500’s return over the past year.
The approach certainly has an appealing narrative: as the crowd zigs to adopt smart beta, we zag. But has it worked?
To test this concept, we wanted to identify what we call “factor orphans”: those securities not held by any factor portfolio. Once identified, we can build a portfolio holding these stocks and track its performance over time.
As a quant, this idea strikes us as a little crazy. A stock not held in a value, momentum, low volatility, or quality index is likely one that is expensive, highly volatile, with poor fundamentals and declining performance. Precisely the type of stock factor investing would tell us not to own.
But perhaps the fact that these securities are orphaned means that there are no more sellers: the major cross-section of market strategies have already abandoned the stock. Thus, stepping in to buy them may allow us to offload them later when they are picked back up by these systematic approaches.
Perhaps this idea is crazy enough it just might work…
To test this idea, we first sought to replicate four common factor benchmarks: the S&P 500 Enhanced Value index, the S&P 500 Momentum index, the S&P 500 Low Volatility index and the S&P 500 Quality index. Once replicated, we can use the underlying baskets as being representative of the holdings for factor portfolios is general.
Results of our replication efforts are plotted below. We can see that our models fit the shape of most of the indices closely, with very close fits for the Momentum and Low Volatility portfolios.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
The Quality replication represents the largest deviation from the underlying index, but still approximates the shape of the total return profile rather closely. This gives us confidence that the portfolio we constructed is a quality portfolio (which should come as no surprise, as securities were selected based upon common quality metrics), but the failure to more closely replicate this index may represent a thorn in our ability to identify truly orphaned stocks.
At the end of each month, we identify the set of all securities held by any of the four portfolios. The securities in the S&P 500 (at that point in time) but not in the factor basket are the orphaned stocks. Somewhat surprisingly, we find that approximately 200 names are orphaned at any given time, with the number reaching as high as 300 during periods when underlying factors converge.
Also interesting is that the actual overlap in holdings in the factor portfolios is quite low, rarely exceeding 30%. This is likely due to the rather concentrated nature of the indices selected, which hold only 100 stocks at a given time.
Source: Sharadar. Calculations by Newfound Research.
Once our orphaned stocks are identified, we construct a portfolio that holds them in equal weight. We rebalance our portfolio monthly to sell those stocks that have been acquired by a factor portfolio and roll into those securities that have been abandoned.
We plot the results of our exercise below as well as an equally weighted S&P 500 benchmark.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
While the total return is modestly less (but certainly not statistically significantly so), what is most striking is how little deviation there is in the orphaned stock portfolio versus the equal-weight benchmark.
However, as we have demonstrated in the past, the construction choices in a portfolio can have a significant impact upon the realized results. As we look at the factor portfolios themselves, we must acknowledge that they represent relative tilts to the benchmark, and that the absence of one security might actually represent a significantly smaller relative underweight to the benchmark than the absence of another. Or the absence of one security may actually represent a smaller relative underweight than another that is actually included.
Therefore, as an alternative test we construct an equal-weight factor portfolio and subtract the S&P 500 market-capitalization weights. The result is the implied over- and under-weights of the combined factor portfolios. We then rank securities to select the 100 most under-weight securities each month and hold them in equal weight.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
Of course, we didn’t actually have to perform this exercise had we stepped back to think for a moment. We generally know that these (backtested) factors have out-performed the benchmark. Therefore, selecting stocks that they are underweight means we’re taking the opposite side of the factor trade, which we know has not worked.
Which does draw an important distinction between most underweight and orphaned. It would appear that factor orphans do not necessarily create the strong anti-factor tilt the way that the most underweight portfolio does.
For the sake of completion, we can also evaluate the portfolios containing securities held in just one of the factor portfolios, two of the factor portfolios, three of the factor portfolios, or all of the factor portfolios at a given time.
Below we plot the count of securities in such portfolios over time. We can see that it is very uncommon to identify securities that are simultaneously held by all the factors, or even three of the factors, at once.
Source: Sharadar. Calculations by Newfound Research.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
We can see that the portfolio built from stocks held in just one factor (“In One”) closely mimics the portfolio built from stocks held in no factor (“In Zero”), which in turn mimics the S&P 500 Equal Weight portfolio. This is likely because the portfolios include so many securities that they effectively bring you back to the index.
On the other end of the spectrum, we see the considerable risks of concentration manifest in the portfolios built from stocks held in three or four of the factors. The portfolio comprised of stocks held in all four factors simultaneously (“In Four”) not only goes long stretches of holding nothing at all, but is also subject to large bouts of volatility due to the extreme concentration.
We also see this for the portfolio that holds stocks held by three of the factors simultaneously (“In Three”). While this portfolio has modestly more diversification – and even appears to out-perform the equal-weight benchmark – the concentration risk finally materializes in 2018-2019, causing a dramatic drawdown.
The portfolio holding stocks held in just two of the factors (“In Two”), though, appears to offer some out-performance opportunity. Perhaps by forcing just two factors to agree, we strike a balance between confirmation among signals and portfolio diversification.
Unfortunately, our enthusiasm quickly wanes when we realize that this portfolio closely matches the results achieved just by naively equally-weighting exposure among the four factor portfolios themselves, which is far more easily implemented.
Source: Sharadar. Calculations by Newfound Research. Past performance is not an indicator of future results. Performance is backtested and hypothetical. Performance figures are gross of all fees, including, but not limited to, manager fees, transaction costs, and taxes. Performance assumes the reinvestment of all distributions.
Conclusion
To achieve differentiated results, we must take a differentiated stance from the market. As systematic factor portfolios are more broadly adopted, we should consider asking ourselves if taking an anti-factor stance might lead to contrarian-based profits.
In this study, we explore the idea of factor orphans: stocks not held by any factor portfolio at a given time. Our hypothesis is that these orphaned securities may be systematically over-sold, leading to an opportunity for future out-performance if they are re-acquired by the factor portfolios at a later date.
We begin by replicating four factor indices: the S&P 500 Enhanced Value index, the S&P 500 Momentum index, the S&P 500 Low Volatility index, and the S&P 500 Quality index. Replicating these processes allows us to identify historical portfolio holdings, which in turn allows us to identify stocks not held by the factors.
We are able to closely replicate the S&P 500 Momentum and Low Volatility portfolios, create meaningful overlap with the S&P 500 Enhanced Value method, and generally capture the S&P 500 Quality index. The failure to more closely replicate the S&P 500 Quality index may have a meaningful impact on the results herein, though we believe our methodology still captures the generic return of a quality strategy.
We find that, on average, there are over 200 factor orphans at a given time. Constructing an equal-weight portfolio of these orphans, however, only seems to lead us back to an S&P 500 Equal Weight benchmark. While there does not appear to be an edge in this strategy, it is interesting that there does not appear to be a negative edge either.
Recognizing that long-only factor portfolios represent active bets expressed as over- and underweights relative to the S&P 500, we also construct a portfolio of the most underweight stocks. Not surprisingly, as this portfolio actively captures a negative factor tilt, the strategy meaningfully underperforms the S&P 500 Equal Weight benchmark. Though the relative underperformance meaningfully dissipates in recent years.
Finally, we develop portfolios to capture stocks held in just one, two, three, or all four of the factors simultaneously. We find the portfolios comprised stocks held in either three or four of the factors at once exhibit significant concentration risk. As with the orphan portfolio, the portfolio of stocks held by just one of the factors closely tracks the S&P 500 Equal Weight benchmark, suggesting that it might be over-diversified.
The portfolio holding stocks held by just two factors at a time appears to be the Goldilocks portfolio, with enough concentration to be differentiated from the benchmark but not so much as to create significant concentration risk.
Unfortunately, this portfolio also almost perfectly replicates a naïve equal-weight portfolio among the four factors, suggesting that the approach is likely a wasted effort.
In conclusion, we find no evidence that factor orphans have historically offered a meaningful excess return opportunity. Nor, however, do they appear to have been a drag on portfolio returns either. We should acknowledge, however, that the adoption of factor portfolios accelerated rapidly after the Great Financial Crisis, and that backtests may not capture current market dynamics. More recent event studies of orphaned stocks being added to factor portfolios may provide more insight into the current environment.