Stock Factor Exposures

Equity factors are characteristics identified by academics and hedge fund managers that influence stock performance and returns. Factors are used as the foundation quantitative models used to predict stock market performance.

The Fama-French factors and AQR factors are the most important factors. The Fama-French three-factor model explains stock returns through market risk, size, and value factors. AQR Capital Management expanded on this concept by identifying additional factors that could explain variations in stock returns.

Fama-French Factors

The Fama-French model introduced two key factors beyond market risk factor to explain variations in returns of different stocks:

  1. Size (Small Minus Big - SMB): This factor captures the historic tendency for stocks of smaller companies to outperform stocks of larger companies.

  2. Value (High Minus Low - HML): This factor represents the historical trend of stocks with higher book-to-market ratios (value stocks) outperforming those with lower book-to-market ratios (growth stocks).

AQR Factors

AQR Capital Management, led by Cliff Asness, extended the factor-based investing approach by identifying several other factors that they argued were significant in explaining the variance in stock returns.

Momentum

Momentum refers to the tendency of securities to continue in their existing trend over time. Stocks that have performed well in the past are expected to continue performing well in the short to medium term, and vice versa for poorly performing stocks. This factor captures the profits generated by investing in winners and selling losers.

Quality

Quality captures the performance of stocks of companies that are characterized by low debt, stable earnings, consistent asset growth, and strong corporate governance. High-quality companies tend to generate stable profits and are deemed safer investments, especially in turbulent markets.

Low Volatility

Low Volatility suggests that stocks with lower volatility, or risk, tend to outperform higher volatility stocks over time. This factor challenges the traditional risk-return trade-off, suggesting that investors can achieve superior risk-adjusted returns by focusing on lower-risk securities.

Carry

Carry in equity investing involves buying stocks that are expected to offer higher dividend yields and selling those with lower yields. In a broader financial context, the carry factor refers to the practice of borrowing at lower interest rates and investing in assets that provide higher returns, capturing the spread between the two.

Defensive

The Defensive factor, closely related to low volatility, identifies stocks that have lower beta or are less sensitive to the overall market movements. These stocks are expected to provide more stable returns, especially beneficial during market downturns.