What is factor-based indexing?
The most commonly understood risk factor is ‘market risk’ – if the broad market moves in a direction, there is a certain degree of correlation for all of the stocks within the index . The capital asset pricing model articulates this type of risk factor. It was soon discovered that market risk did a poor job in explaining returns and that there were other factors that could enhance the predictability of asset returns. The Fama French three factor equity model (1991) included the small capitalization effect and the value effect. In 1997, Mark Carhart extended the Fama French model to also include momentum. The catalog of potential equity factors continues to expand, and now includes reversal, low volatility, quality and liquidity.
Factor-based indexing is simply including parameters other than market capitalization when determining weighting for constituents of the index universe.
Advantages of multi-factor vs. single factor
The main reason that the Atlas strategy has been able to deliver consistent outperformance is the utilization of multiple factors at once.
On average, these factor exposures have delivered positive returns. However, each individual factor experiences periods of underperformance.
The factors tend to underperform at different times – so combining multiple factors provides a higher probability that the overall strategy is generating additional return for the investor.
The value factor
The momentum factor
The reversal factor
Short term reversal stocks, as measured by the 20% worst performing stocks over the prior one month, have outperformed the market in 42 of the last 50 years (84%). The outperformance has averaged 11.25%.
The inclusion of the reversal factor is one of the unique characteristics of the Atlas strategy. This factor has the strongest historical performance, but also the highest transaction costs.