Finding Your Factors

By Dr. Felix Kleinstein

Question from respected colleague:

I need some help deciding which factors to use in building my first models. There are a number of funds I like and have used for years, and I just want to find more funds like them. Is there some trick to this?

Answer from Felix:

No, there’s no trick, just a scenario or two. You already know the funds you like; you just need to find out why you like them. If you can determine what those aspects are, then you can use the factors associated with them to build scenarios to find similar funds. The process is fairly simple, and as an extra bonus, you’ll also learn about your own investing preferences.

Start by dividing the funds you like into three types: stocks, bonds, and hybrids (blends). Within each type, divide them further into specific categories such as Large Cap Value or Intermediate Government Bond. In some categories you may have only one; in others you may have several. That’s OK.

Now for the step-by-step process:

1. Create a new scenario for the first major type you want to model and name it accordingly (“Equity,” “Fixed Income,” or “Hybrid”). On the Category Selection page, select “Fund” as product type, “Stock,” “Bond,” or “Hybrid” to correspond to the scenario name, and “All” for track record. Hit the Continue button and when the screen updates, select every category of funds listed. Click on Update and then Save Selections.
2. Don’t worry with the Preference tab; go directly to the Results. Pick one of the categories within the type (e.g. Large Cap Value in Equity). Now use the “Find” link at the top of the Results page to locate your first fund in the category. When K⁴ returns the fund’s link, click on it and then select “Summary.”
3. On the next page, click “Cancel” to return to the prior page, and there click on “Previous” so you can enter the name or ticker of the next fund to locate. Repeat the procedure for up to four funds in the category.
4. Once you have your four funds, return to the Results page and change the “Sort” option from “Rank” to “Selected for Summary” and click on “Update.” This will bring all the funds you selected to the top of the results list.
5. Mark the check boxes in the “Comparison” column corresponding to the funds marked for Summary. (Don’t mark more than four, or you’ll get an error message asking you to uncheck the extra ones.)
6. Click on “Show Comparison” at the bottom of the Results page. This will bring up the Comparison Report for the selected funds. Now you’re ready to do some analysis.

As you probably already know, the Comparison Report shows all of K⁴’s factors for the funds and their related benchmarks. They’re divided into groups such as “Risk” and “Value Added” to make the report easy to use and navigate. Look through the report to find those factors where your funds do well and ask yourself how important those are to you. Pay particular attention to these groups: Risk, Return, and Value Added. Your goal is to find a total of 5-10 factors where your funds do well and that you feel are important, drawing at least one from each of these three groups. These factors can be the starting point in creating a scenario for that particular fund type and category. This process can then be repeated for each of your remaining groups.

Once you’ve selected your factors, you’re ready to build your scenarios. Name your first scenario to reflect the specific fund type and category you’re using, and select your desired track record. Check off the factors on the Preference page and use the Preference Questionnaire to help assign weights to the various factors. On the Results page, apply any filters you feel appropriate and again use the “Find” link to locate your favorite funds in the scenario. If they rank highly, you’ll probably be satisfied with the scenario. You may also want to consider reviewing and possibly using some of the other funds that rank highly, too. On the other hand, if your favorite funds don’t score well, you might revise the weights you assigned to the various factors or you may even want to go back to the original Comparison Report to consider alternative factors.

This can be an iterative process and will require you to do some analysis. In the end, however, you’ll not only end up with the scenarios you want, you’ll also get some insight into your own investment approach. How’s that for an added bonus?