Factor Finesse

Robert Bergson admits that the fund he manages, the Northern Trust Small Cap Core Fund, isn’t likely to surge to the top of the performance charts for any given year. To the veteran manager, who has run small-cap portfolios since 1999, that’s really not the point anyway.

“We look to produce above-benchmark returns over the long term without increasing risk,” he says. “In the process, we’re likely to hit more singles and doubles than home runs.”

Bergson aims to achieve that modest goal using a strategy based on factor investing, a focus of new product introductions in the ETF world, but a strategy that has a much smaller following among mutual funds. In contrast to fundamental valuation techniques, which look at company-specific characteristics such as earnings or cash flow, this fund and others offered by Northern Trust focus on “factors” that tend to drive risk and return. These include a stock’s value, price momentum, volatility, size and quality.

Tricky Business

Proponents of factor investing point to academic research suggesting that using the factors can generate higher risk-adjusted returns than the market. But applying factor-based methodology successfully has proved to be a tricky business for even the most sophisticated investors. A recent study of 500 institutional portfolios by Michael Hunstad, head of quantitative research at Northern Trust Asset Management, found that most were using factors in a less than optimal manner and getting disappointing investment results. Some combined factor-based portfolios with other investment management strategies, which muted the benefits of factor investing. Others fell short because they failed to combine factors in their portfolios effectively.

Putting together a multifactor portfolio, as this fund does, is kind of like cooking. A recipe using good ingredients in the right proportion yields a tasty dish, while the wrong mix results in a bland concoction. Similarly, the success or failure of multifactor ETFs and mutual funds rests on the components they use and how they’re put together.

In this fund, which relies almost exclusively on quantitative analysis, Bergson and his team try to avoid both stocks that could become value traps as well as those exhibiting signs of unsustainable growth. To do that, they toss out what their models consider the lowest quality stocks in their benchmark, the Russell 2000 Index, and keep the better ones in. Companies can show signs of potential underperformance by suffering declining profit margins or weakening cash flow or by demonstrating an excessive need to tap capital markets for growth rather than to achieve it organically. A momentum factor means that stocks whose prices have been floundering for a while also land on the low-quality list and are ripe for a sale.

The methodology is designed to weed out the losers rather than pinpoint the winners. “Low quality stocks tend to underperform over the long term,” Bergson says. “At the same time, it’s easier to identify characteristics of small companies that are likely to underperform than those that are likely to outperform.”

The fund looks similar in some respects to the Russell 2000. It spreads its bets widely among 1,599 holdings, just shy of the 1,976 index names. It has a similar trailing 12-month price-to-earnings ratio, as well as a nearly matched price-to-book ratio. The fund’s sector allocations are similar to those of the benchmark, and its turnover is a modest 21%. The low turnover helps tax efficiency, while having a large number of holdings circumvents some of the liquidity issues that can arise when institutional investors trade large blocks of stock in small companies.