What is the best way to predict success?

In baseball, the game’s strategy was forever changed when Oakland Athletics traded in the standard scout’s intuition for a data-driven approach. It was a switch that eventually led the team to an impressive 20-game winning streak, depicted in the movie Moneyball—it also kickstarted a broader revolution in sports analytics.

Similarly, successful data patterns are also being discovered by experts in the investing world. One such framework is factor investing, where securities are chosen based on attributes that are commonly associated with higher risk-adjusted returns.

Factor Investing 101

Today’s infographic comes to us from Stoxx, and it explains how factor investing works, as well as how to apply the strategy in a portfolio.

A Selective Approach

There are two main types of factors. Macroeconomic factors, such as inflation, drive market-wide returns. Style factors, such as a company’s size, drive returns within asset classes.

Analysts have numerous theories as to why these factors have historically outperformed over long timeframes:

• Rewarded risk
  Investors can potentially earn a higher return for taking on more risk.
• Behavioral bias
  Investors can be prone to acting emotionally rather than rationally.
• Investor constraints
  Investors may face constraints such as the inability to use leverage.

Astute investors can capitalize on these biases by targeting the individual factors driving returns.

The Common Style Factors

Based on academic research and historical performance, there are five style factors that are widely accepted.

1. Size: Smaller companies have historically experienced higher returns than larger companies
2. Low Risk: Stocks with low volatility tend to earn higher risk-adjusted returns than stocks that have higher volatility.
3. Momentum: Stocks that have generated strong returns in the past tend to continue outperforming.
4. Quality: Quality is identified by minimal debt, consistent earnings, steady asset growth, and good corporate governance.
5. Value: Stocks that have a low price compared to their fundamental value may generate higher returns.

It is becoming more straightforward for investors to implement these factors in a portfolio.

How Can You Apply Factor Investing?

All investors are exposed to factors whether they are aware of it or not. For example, an investor who puts capital in an ESG fund—targeting companies with good corporate governance—will have some level of quality exposure.

However, there are various approaches investors can take to implement factors intentionally.

Single Factors

Factors perform differently over the course of a market cycle. For example, low volatility stocks have historically performed well during market downturns such as the 2008 financial crisis or the 2015 sell-off.

Investors can consider macroeconomic information and their own market views, and adjust their exposure to individual factors accordingly.

Multi-factor

Factors tend to exhibit low or negative correlation with each other. For a long-term strategy, investors can combine multiple factors, which increases portfolio diversification and may provide more consistent returns.

Long-short

For each factor, there are investments that lie on either end of the spectrum. Experienced, risk-tolerant investors can employ a long-short strategy to play both sides:

• Hold long positions in attractive securities, such as those with upward momentum
• Hold short positions in unattractive securities, such as those with downward momentum

This diversifies potential return sources, and reduces aggregate market exposure.

Capturing Factors Through Indexing

Active managers have been selecting securities based on factors for decades. To capture factors with precision, managers must carefully consider numerous elements of portfolio construction, such as the starting investment universe and the relative weight of securities.

More recently, investors can access factor investing through another method: indexing. An indexing approach provides a framework for capturing these factors, which helps simplify the investment process. Based on objective rules, index solutions provide a higher level of transparency than some active solutions.

Not only that, their efficiency makes them more suitable as tools for building targeted outcomes.

The Future of Factors

In light of indexing’s various benefits, it’s perhaps not surprising that exchange-traded factor products have seen immense growth in the last decade.

In addition, there’s still plenty of room for factor ETF expansion in equities and other asset classes. Only about 1% of factor ETFs invest in fixed income, and 70% of surveyed institutional investors believe factor investing can be extended to the asset class.

As solutions continue to evolve, factor products could become the foundation of many investors’ portfolios.



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Visualizing Unequal State Tax Burdens Across America

What percentage of your income goes into Uncle Sam’s pocket?

Your answer will vary depending on how much you earn. Data shows that low and middle-income families pay a much greater share of their income towards state and local taxes than wealthy families.

Today’s visualization uses data from the Institute on Taxation and Economic Policy (ITEP) to map the effective tax rates—or taxes paid as a share of family income—across income groups at the state and local level.

Crunching the Numbers

The data reflects the effect of tax changes enacted through September 10, 2018, using 2015 income levels (the latest year for available, detailed income data). Both single and married tax filers are included, while elderly taxpayers, dependent filers, and those with negative incomes are excluded.

Taxes Included
The report includes the state and local taxes for all 50 states and the District of Columbia. Taxes are broken into 3 broad groups:

• Consumption taxes – general sales taxes and specialized excise taxes
• Property taxes – including taxes on homes, businesses, and motor vehicles
• Income taxes – paid by individuals and businesses

Federal taxes are not considered.

Editor’s note: It’s worth noting that federal personal income tax has progressive rates, with the lowest earning bracket at 10% and the highest earning bracket at 37% in 2019. At a national level, property taxes are not charged and there is a very low reliance on excise taxes—both of which tend to be regressive as outlined below.

Income Included
The report includes both taxable and tax-exempt income such as worker’s compensation benefits. It also includes estimates for the amount of unreported income.

Which States Have the Most Unequal Tax Burdens?

Across the U.S., there is a wide disparity in how taxes affect different income groups. Here’s how it all breaks down, ranked in order of tax system inequality*:

Total State and Local Taxes As a Share of Income
By State and Income Group

* The ITEP Tax Inequality Index measures the effects of each state’s tax structure on income inequality. In states that rank high for inequality, incomes are less equal after state and local taxes are applied than before. On the flip side, states with the most equality are those where incomes are at least somewhat more equal after state and local taxes are levied than before.

Washington has the most unequal tax burdens. Proportional to their income, Washington taxpayers in the bottom 20% pay almost 6x more than those in the top 1%.

At the other end of the scale, California has the most equal tax system. As a share of their income, the state’s poorest families pay only 0.84x what the wealthiest families pay.

Overall, however, the vast majority of tax systems are regressive.

On average, the lowest 20% of income earners pay 1.54x more of their income in taxes compared to the top 1%.

The Main Causes

Two main factors drive a tax system’s (lack of) equality: how the state designs each tax, and the state’s reliance on different tax sources.

To better explain how this works, let’s take a closer look at each type of tax.

Sales & Excise Taxes

These taxes apply only to spent income, and exempt saved income. Since families with a higher household income are able to save a much larger percentage of their income, and the poorest families can barely save at all, the tax is regressive by nature.

The particular types of items that are taxed affect fairness as well. Quite a few states include food in their sales tax base, and low-income families spend the majority of their income on groceries and other necessities.

Not only that, excise taxes are levied on a small subset of goods that typically have a practical per-person maximum. For example, one person can only use so much fuel. As a wealthy family’s income increases, they generally do not continue to increase their spending on these goods.

States rely on these taxes more than any other tax source, which only exacerbates the problem.

Property Taxes

For the average household, the home makes up the majority of their total wealth—meaning most of their wealth is taxed. However, the wealth composition of richer families skews much more heavily towards stock portfolios, business equity, and other assets, which are exempt from property taxes.

While these types of assets are subject to taxes like capital gains and dividends, the distinction is that these taxes are levied only on earned gains. In contrast, property taxes are owed simply as a result of owning the asset.

What about those who don’t own homes? Landlords generally pass on the cost of property tax to renters in the form of higher rent. Since rent comprises a much higher share of expenses for poorer families, this makes property tax even more inequitable.

Income Taxes

State income taxes are typically progressive. This means effective tax rates go up as income goes up. Here’s how the U.S. averages break down:

• Low-income families: 0.04%
• Middle-income families: 2.1%
• Top 1%: 4.6%

However, certain policy choices can turn this on its head. Some states have a flat rate for all income levels, a lack of deductions and credits for low-income taxpayers, or tax loopholes that can be beneficial for wealthier income groups.

Nine states charge no income tax at all, garnering reputations as “low tax” states—but this is true only for high-income families. In order to make up for the lost revenue, states rely more heavily on tax sources that disproportionately affect the lowest earners.

Evidently, states with personal income taxes have more equitable effective tax burdens.

Tackling Systemic Issues

Regressive state tax systems negatively impact the after-tax income of low and middle-income families. This means they have less to spend on daily expenses, or to save for the future.

Not only that, because wealthier families aren’t contributing a proportional share of tax dollars, state revenues grow more slowly.

For states looking to create a more equitable tax system, states with progressive systems offer some guidance:

• Graduated income tax rates
• Additional tax over a high-income threshold (e.g $1 million)
• Limits on tax breaks for upper-income taxpayers
• Targeted low-income tax credits
• Lower reliance on regressive consumption taxes

By implementing such policies, governments may see more tax equality—and more tax dollars for programs and services.

Hat tip to reddit user prikhodkop, whose visualization introduced us to this data.