Factor Investing in the American Stock Market: Risks and Returns of Factor Investing & the Implications of Interest Rate Regimes, Industry Allocation and Trading Costs

Abstract

This thesis focuses on the Quality, Value, Momentum, Size, and Low Volatility factor strategies and how the risk-adjusted returns for these factors have been from 1971 until 2022 as well as how the excess returns of the benchmark are during high, normal, and low interest rate regimes. Furthermore, the industry allocation of the factor portfolio was analysed to see if this could be a contributor of the excess return of the benchmark rather than a stock picking caused by the underlying factor. Lastly, the effect of brokerage fees as trading cost is analysed at the monthly rebalancing for the factors. The analyses within this thesis showed that all factors except small cap had significantly higher risk-adjusted returns compared to the CRSP benchmark when measured by Sharp ratio. The Quality and Low Volatility factor portfolios had the most significant risk-adjusted returns. The excess returns of the benchmark could be explained by certain industry allocations for Momentum, Value, Low Volatility and Quality factor strategies. The biggest industry allocation effect measured were for the Momentum factor whereas the significance was lower for the Quality factor. The small cap factor portfolio showed no excess return of the benchmark. Stocks generally showed higher risk-adjusted returns during the low interest rate regime than the high interest rate regime. This was also the case for the excess returns of the benchmark for the Quality and small cap factor. The Value and Momentum factor had higher excess returns of the benchmark during the high interest rate regime and lower during the low interest rate regime. The Low Volatility factor had higher excess returns of the benchmark in the high and low interest rate regimes and the lowest in the normal interest rate regime. The transaction brokerage fee cost added to the factor portfolios affected the Momentum factor portfolio the most since the number of stocks rebalanced in this portfolio were the highest. The Momentum and small cap factor portfolios had insignificant risk-adjusted returns after the fee cost were considered.