Market insights Multi-Asset Solutions

October 2017

How factors influence equity and fixed-income returns

In the following chart, the bars represent the estimates’ t-values,
which are a statistical measure of equities’ estimated sensitivity to a
Dr. Brian Jacobsen, CFA, CFP® given variable (in this case, factors), divided by the degree of uncer-
Senior Investment Strategist tainty around those estimates. In our charts, a t-value reading of +1.96
Multi-Asset Solutions or -1.96 indicates whether a given factor was statistically different
from zero with a 5% level of significance—and in the instances of
higher or lower readings, this helps us understand the extent to which
The standard view of describing what happened in a segment of the mar- a given factor may influence equity returns, over time.
ket is to discuss how different indexes performed. However, if you evolve
your view by using factors—features of securities that can help explain Instead of just thinking about the third quarter by way of indexes—as
returns—you can enrich the story, for both equities and fixed-income. a period in which small caps, growth, IT, and Energy did well—factors
show us that Q3 was actually a quarter where lower quality, higher
How did stocks and bonds perform in the third quarter of 2017? Let’s momentum, and less-liquid stocks did better than securities with the
start with the standard view, using indexes to assess what did, and opposite characteristics. At a 90% confidence level (a t-value of 1.65),
didn’t, do well. you can see that more volatile stocks did better than less volatile
stocks, as did companies with better social records compared to those
Third-quarter performance Index-based metrics with worse social records.
Small cap stocks outperformed  Russell 2000 Index: +5.57%
large cap stocks  S&P 500 Index +4.32% How 10 factors influenced equity returns in the third quarter of 2017
Value stocks underperformed  Russell 3000 Value Index:
T-value: Equity returns’ sensitivity to factors (estimate divided by standard error)

growth stocks +3.08%

 Russell 3000 Growth Index 6
+5.82% 5
Best-performing sectors:  S&P 500 Information
Information technology (IT) Technology Index: +8.54 4
and energy  S&P 500 Energy Index: +6.60% 3
Worst-performing sector:  S&P 500 Consumer Staples
2 +1.96
Consumer staples Index: -1.55%
1
Sources: FactSet and Author’s calculations. Index definitions.
0

Now let’s look at performance through the lens of factors. -1

There is a wide body of academic evidence showing how factors -2
-1.96
might explain why some securities do well and some do poorly over
-3
long periods of time. For equities, I used the following variables to tell
a more complete story. This approach was inspired by a method from -4
the 10-2-17 research paper, Primer on Factor Exposures and Payoffs,
Market capitalization

Free cash flow yield

Free cash flow stability

Trailing 12-month return

long-term growth rate

Trailing 12-month price volatility

Environmental Score

Social Score

Governance Score

Trading volume
Earnings per share expected

co-authored by Wells Fargo Asset Management’s Harindra de Silva,

which is published on the Social Science Research Network (SSRN).

Factor Proxy
Size Market capitalization
Value Free cash flow yield
Quality Free cash flow stability Sources: Author’s calculations, using beginning-of-quarter characteristics and third-quarter 2017 returns
Momentum Trailing 12-month total return of all listed U.S. equities from the U.S. FactSet Market Aggregate.
Growth Expected long-term earnings per share growth
Volatility Trailing 12-month stock price volatility
For fixed income, I used the same variables from above, to see what
ESG MSCI’s Environmental, Social, and Governance scores
the stock characteristics could tell us about fixed income performance.
Liquidity Previous month’s average trading volume, as a percent
of shares outstanding

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Market insights | October 2017

However, I also included the standard features of three more factors: The factor-based analysis provided a few more insights about
yield-to-worst, duration, and convexity. Those additional metrics may third-quarter equity and fixed-income performance that I found
tell us how bond prices change when yields change. interesting:
 Companies whose stock prices had been depressed over the past
In short, fixed income had an even more interesting third quarter, 12 months had bond returns that did better than those with stocks
from a factor perspective. whose prices had advanced.
 Companies where analysts were expecting faster long-term growth
The standard story—again, based on index performance—would be also did better than companies from which analysts were expecting
that high yield did well, with the BofA Merrill Lynch U.S. High Yield lower growth.
Index returning 2.02% for the quarter. That’s reflected in the chart  More liquid bonds with higher trading volume also did better than
below, where the yield-to-worst (YTW) had a positive payoff for the less liquid names
quarter. Therefore, higher yield names did, generally, have higher
returns than lower-yielding securities for the quarter. But here’s how It’s fascinating that companies with lower environmental and
factors can enrich the story: governance scores did better than those with better scores, but a lot
 The debt of larger companies did better than the debt of smaller of that may be attributable to the specific industries that did well. To
companies see this, I included indicator variables for every industry in the MSCI
 Companies with more stable free cash flows also did well global industrial classification system and it showed utilities, energy,
and metals and mining companies having higher returns than other
Therefore, while high yield did well in the third quarter, it wasn’t industry groups, even though they don’t always rank highly with their
merely a “junky” rally. environmental scores. Similarly, issues in the biotechnology industry
performed well, and they tended to rank lower on the governance scale.
How 13 factors influenced fixed-income returns in the third
quarter of 2017 Final thoughts
Statistically, factors have proven over time to be important determinants
T-value: Fixed-income returns’ sensitivity to factors (estimate divided by standard error)

of securities’ returns. They’ve been very useful in building portfolios.

14 However, they are also useful for helping to make sense of what
12 happened in the market. Many indexes are highly correlated with
10
each other, and sometimes the differences can be a matter of noise.
Factors create distinctions that make a difference, at least statistically.
8
They provide a different angle for looking at investment performance,
6 analyzing risks, managing portfolios, and knowing what you own.
4
2 +1.96

0
-2
-1.96
-4
-6
-8
Yield to worst

Duration

Convexity

Market cap of issuer

Free cash flow yield of issuer's stock

Free cash flow yield stability

Trailing 12-month return on issuer's stock

Earnings per share expected long-term growth rate

Trailing 12-month stock price volatility of issuer

Environmental Score

Social Score

Governance Score

Bond trading volume

Sources: Author’s calculations, using beginning-of-quarter characteristics and third-quarter 2017 returns
of publicly traded companies with a.) Debt listed in the BofA Merrill Lynch U.S. Corporate and U.S. High
Yield indexes, and b.) Equity listed in the U.S. FactSet Market Aggregate

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Market insights | October 2017

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