Investors experiment with different factors and models to find a trading edge that holds up over time. Since the 1960s, traders used the Capital Asset Pricing Model to determine the optimal risk-return tradeoff of a security or portfolio. It’s the most basic factor model and suggests a single beta factor influences the risk-adjusted returns of an asset. Later research from Fama and French demonstrated the size and valuation of a company are equally important in explaining investment returns.
Today, investors use hundreds of different factors to better identify risk and reward opportunities. These same factors can apply to other areas of the real world like the NBA where player’s stats are associated with future gameplay. With a basic overview of the most popular factors, we can attempt to build an optimal factor based NBA team.
The foundations of factor investing
Minimum Volatility: A strategy designed to deliver market like exposure with below-market risks. This factor style serves conservative investors seeking exposure to stocks with less significant drawdowns than a traditional portfolio. Some minimum volatility stocks include McDonald’s, Visa, and Johnson & Johnson.
Size: Captures excess returns of small-cap companies relative to large and mid-cap stocks. In most cases, small-cap stocks offer greater upside growth than large established companies.
Value: Value investing is about finding bargains—stocks that have underperformed without a significant drop in fundamentals. Using indicators like price-to-book and price-to-earnings will help distinguish underappreciated stocks from lemons. However, the current bull market has punished value plays in favor of momentum.
Momentum: Stocks that have outperformed in the past tend to record greater returns going forward. A simple momentum strategy takes a long position in an asset that has reached a new all-time or 52 week high.
Quality: Companies with strong fundamentals like low debt, high earnings growth, and stable corporate governance fall under the quality label. The iShares Edge MSCI USA Quality Factor ETF tracks return on equity, earnings variability, and debt to equity to determine investments.
A five-Factor starting lineup
PG-Isaiah Thomas (Value): Part of Cleveland’s struggles this season is Isaiah’s slow bounceback from a hip injury. His 28 ppg in the regular season last year was a core reason the Cavs parted ways with Kyrie Irving. The hope is, like many value stocks, he will regain some momentum and become the same offensive threat for the Cavs.
SG-James Harden (Momentum): After nearly winning the MVP in 2017 it was unclear if the beard could post a repeat performance. But James Harden has silenced the critics. He’s learned to coexist with future hall of famer, Chris Paul, and looks like a near lock to win the prestigious award this year. In the investing world, NVidia has embarked on a similar journey. The stock nearly tripled in early 2016 and experts called it a top but last year shares continued rolling, jumping another 100%. Today, the chip maker is up over 20% year to date with no sign of slowing down.
SF- Jayson Tatum (Size): Danny Ainge hit the jackpot by trading down from the first overall pick to select Jayson Tatum. His rare blend of size, skill, and poise at 19 years old has experts believing Boston may have found the next Paul Pierce. Much like drafting a future superstar, investing in small-cap stocks can reap similar returns.
PF- Lebron James (Quality): The Cavaliers star is playing some of the best basketball in his illustrious 15-year career, posting recent highs in almost every counting stat. King James is widely considered the best player in the league, which makes this comparatively straightforward. Apple is the largest investment in the iShares Quality ETF and consistently generates more profit than any other company each quarter. The best player in the NBA and most valuable company naturally fit the definition of quality.
C- Marc Gasol (Minimum Volatility): Each year Marc Gasol delivers the same stat line regardless of the Grizzlies’ record. He can be counted out for about 15 points, 8 rebs, and 2 blocks when the team is in a slump or racking up wins. It may never wow the casual fan but he certainly won’t disappoint. Investors look for similar consistency when determining asset allocations. Assets with low volatility like consumer staples often outperform the broader market during a downturn.