Two Types of Factors: A Return Decomposition for Factor Portfolios

Abstract

The author decomposes the returns of quantitative long–short factor portfolios to those attributable to “fundamental return”—the return due to underlying business operations—and those attributable to “multiple expansion”—the return due to the change in the market valuation of those businesses. He does so by aggregating the statistics of the underlying stocks held in each leg of the portfolios over their respective holding periods. The author identifies two types of factors differentiated by the source of performance. The first type, of which the value factor is an example, outperforms because it identifies businesses whose valuations are subsequently bid up relative to the market; and despite that, it invests in “bad” businesses, or those that subsequently grow capital by less than average. In other words, its outperformance is entirely attributable to market behavior. The second type, of which momentum and quality (gross profitability to assets) are examples, outperforms because it identifies “good” businesses, or those that subsequently grow capital by more than average, and despite investors subsequently lowering their relative valuations.

TOPICS: Fundamental equity analysis, statistical methods, analysis of individual factors/risk premia, performance measurement