Re-Thinking the Value Factor

Recapping our current income portfolios: 

DFMAP (Dividend Focused Multi-Asset Portfolio) 
TAC (Treasuries Across the Curve)
VWI (Volatility Weighted Income)

Please reach out if you would like to learn more about them. 

We have been busy on our product development at Arch Indices and wanted to share a preview of what we have been working on. The Arch mission is portfolio optimization: getting to the goal with the least amount of volatility. A portfolio cannot be optimized without achievable goals and a proper framework. 

In quantitative frameworks, all securities have observable and measurable factors. Over the long-run, a select group of factors drive returns while most are noise. The most common factors are: momentum, growth, value, size, minimal volatility, income, and quality. Within the passive space there are debates on how to weight the portfolio, inclusion/exclusion of securities, and how to rebalance. 

Factors need to be updated to reflect today’s market structure. Value is an excellent example of a factor that has worked over the long-run but in need of a refresh. Many value factors use price-to-book and price-to-earnings ratios which reflect an earlier era of investing and the economy. 

For the majority of companies today, price-to-book is not a relevant measure as technology, brands, and intellectual property are drivers of enterprise value. Companies and investors today increasingly look at operating and free cash flow as the metric of corporate performance. We have seen increasing investor interest in free cash flow ETFs over the last several years and decreasing interest in the traditional value funds. The free cash flow metric is another form of value.

An ETF that just uses inverse rank on free cash flow is another arbitrary way of portfolio construction. We ran an optimization on an index of the 30 “most important” US equities (DJIA) with free cash flow as the factor goal of the portfolio with the weighting to minimize overall portfolio volatility. For comparison, we added another popular value iteration, the Dogs of the Dow: the 10 highest dividend yielding stocks equally weighted and rebalanced annually.

Factors are not independent and frequently work well together in portfolio construction. We are combining value and minimal volatility to construct a portfolio to deliver risk-adjusted performance. 

We began our optimization at the last re-constitution of the DJIA, 9/1/2020. We note that our backtest has better consistent performance than both the DJIA and the Dogs strategy but slightly higher realized volatility. This is notable in an environment where the traditional value factor has stuggled. 

It is time to refresh, evolve, and optimize the factors. 

Our optimization was run with our proprietary VOI Block methodology with a minimum weight of 1.5% per security and monthly rebalance. 

As always your thoughts and feedback are very much appreciated!