Impacts of Sector and Company Size on Effective Factor Investing:Evidence from U.S. Equity Markets

Abstract

Identifying the stable long term relationship between factors and asset returns is the main challenge of factor investing. By adopting a two-step regression methodology and controlling the impact of the business cycle, this study investigates industry sector, company size and their interactions with common factors in U.S. equity market from January 1990 to December 2016. The two-step regression recorded a significant sector effect and the influence of company size on common equity market factors. When industry sectors are included in the second-step regression, influences of three common factors: market beta, company size, and value factor are largely explained by the risk-free rate, yield curve, and industry sectors. In the large-cap portfolio, the momentum effect on long term equity returns is robust, but the size and value effects disappear. In the small-cap portfolio the momentum, however, is not significant, but the size premium is recorded in long term returns. This study documents that small-cap portfolio’s long term return is mainly determined by changes of the yield curve, credit curve, and industry sectors. These findings are robust when a business cycle dummy variable is introduced to the two-step regression. This study extended factor investing research further by examining influences of sectors and the company size on stock returns in long run: 1) market beta is mostly explained by the change of risk free rate, yield curve, and industry sectors; 2) the momentum is a determinant factor in large-cap portfolio, but not small-cap portfolio; 3) The return of small-cap portfolio is predominantly attributed to sector exposures, changes of the credit curve and yield curve. We conclude that for effective factor investing in large-cap portfolio, right sector rotation and market momentum strategies must be implemented, while in small-cap portfolio changes of yield curve and credit curve are determining factors.

Keywords: factor investing, factor analysis, factor premium, two-step regression, common factors, sectors, yield curve, credit curve

JEL Classification: G11, G12, G14, G15, E44