Broadly speaking, human capital is an intangible asset that encompasses the habits, knowledge, talent, motivation, and experiences of an organization. While widely held to be a critical component to a company's long-term success or failure, it has emerged only recently as an effective investment screen thanks in part to the improved ability to measure the impact of human capital on stock price performance.

Hidden factor affecting share prices

Over the past three years, the global quantitative and derivatives strategy team at J.P. Morgan Securities has analyzed the data behind the human capital factor (or HCF), an approach developed by investment research firm Irrational Capital that seeks to quantify the link between human capital management and equity performance using a combination of public and private data sources.

The proprietary pillar of the data is constructed from the analysis of 2.6 million individual responses to human resources surveys, comprising more than 71 million unique survey data points covering over 1,300 publicly traded U.S. companies and spanning the last 15 years. This dataset includes ratings on the usual and easy-to-measure topics such as compensation, benefits, and training, but adds a wide range of far more important and difficult to measure characteristics of the employee-employer relationship. The HCF is able to deeply evaluate the human side of the organization, and tangibly measure levels of appreciation, pride and trust and the relationship with one's manager, the sense of psychological safety and more within the organization.

The other datasets used in constructing the HCF are derived from public sources that feature company-specific insights. While this dataset is smaller in overall scope (30 million unique data points), it includes coverage of more than 4,200 U.S. companies.

These datasets are combined and then each company's human capital factor score is calculated through an assortment of analytical techniques. The result is a measure of how effectively these organizations treat their team members. This rating is then used as the metric for stock selection. Based on our analysis, the HCF has delivered consistent outperformance.

Further, a trio of ETFs built on the human capital factor all bested their respective benchmarks last year. The index underlying the Harbor Human Capital Factor Unconstrained ETF (HAPY) posted a 35.60% gain in 2023, topping the Russell 1000's return of 24.50%; the index tracked by Harbor Human Capital Factor US Large Cap ETF (HAPI) returned 30.70%, which outperformed the S&P 500's 26.30% total return for the year; and the index tracked by Harbor Human Capital Factor US Small Cap ETF (HAPS), which launched in April 2023, climbed 17.70% through year-end versus 16.90% for the Russell 2000 for the year. Note: All returns are market price of nav.

More than money

In addition to this strong performance, the HCF data also reveals several key insights. Irrational Capital segments the questions and responses to the HR surveys into seven different dimensions. Six dimensions are related to capturing different aspects of intrinsic motivation, including how successful companies are at engaging their staff beyond material and monetary incentives. These dimensions include direct management, innovation, organizational alignment (or employees' feelings on how much they are informed and aligned on the direction, goal and value of the organization) and more.

The common misconception that financial compensation alone determines employee motivation or has an outsized effect on future equity performance is not supported by our analysis. In fact, the only dimension that failed to beat the benchmark over the sample period (since 2012) when run in isolation was extrinsic motivation, which refers to benefits that are external to an individual such as compensation.

While financial rewards are intended to motivate individuals, employees respond to more than compensation and benefits to be highly motivated and productive in the workplace. For example, one dimension that has demonstrated consistent outperformance over time is organizational effectiveness, which describes the ability of a group to achieve its goals and objectives with little waste (effort, time, energy, attention). Organizational effectiveness is a reflection of how well a company is able to utilize their human resources effectively and treat their employees with respect by valuing their time.

Financial services and tech companies making strides

The HCF signals positive long-term performance across all sectors, proving that employees who feel well connected and supported move their company forward, regardless of industry. However, closer analysis reveals the financial services and technology sectors have both demonstrated significant multiyear improvements across all seven dimensions. With companies in both sectors relying heavily on their human capital for growth, it's not surprising to see that firms in these sectors are focused on improving all aspects of how they treat their employees.

Conversely, three sectors experiencing notable declines across the dimensions are consumer, cyclical, energy and real estate. In each of these sectors, human capital may play a more subordinated role relative to tangible assets, commodity prices and other input costs.

Market mispricing opportunity

Among the many variables considered when evaluating securities with an eye toward managing risk and enhancing returns, human capital management has never been "top of mind" — or perhaps credibly accessible — for investors. However, the tide may be turning as the role of human capital in gaining competitive advantage in the knowledge economy is examined in greater detail within the workplace and society at large.

Not coincidently, the tools and data to measure this key asset have simultaneously evolved to more accurately determine which companies treat their people better and how it impacts value creation in the form of future stock price appreciation, which we view as the ultimate measure of performance. As a result of this convergence, investors have an opportunity to tap into an investment factor that is not correctly priced by the market. It turns out that the answer to achieving investment outperformance has been in front of us all along.

Khuram Chaudhry is a managing director and head of European quantitative strategy on J.P. Morgan Securities' global quantitative and derivatives strategy team. He is based in London. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines but is not a product of P&I's editorial team.

Important Information

Investors should carefully consider the investment objectives, risks, charges and expenses of a Harbor fund before investing. To obtain a summary prospectus or prospectus for this and other information, visit harborcapital.com or call 800-422-1050. Read it carefully before investing.

Risks

Investing involves risk, principal loss is possible. Unlike mutual funds, ETFs may trade at a premium or discount to their net asset value. Harbor ETFs are new and have limited operating history to judge.

Shares are bought and sold at market price not net asset value (NAV). Market price returns are based upon the closing composite market price and do not represent the returns you would receive if you traded shares at other times.

HAPI: There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. The Fund may not exactly track the performance of the Index with perfect accuracy at all times. Tracking error may occur because of pricing differences, timing and costs incurred by the fund or during times of heightened market volatility. The Fund relies on the Index provider's methodology in assessing whether a company may be considered a corporate culture leader. There is no guarantee that the construction methodology will accurately assess a company to include or exclude it from the index which could have an adverse effect on the Fund's returns. The Fund's assets may be concentrated in a particular sector or industries to the extent the Index is concentrated and is subject to the risk that economic, political, or other market conditions that have a negative effect on that sector or industry will negatively impact the value of the Fund.

HAPS: There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. Stocks of small cap companies pose special risks, including possible illiquidity and greater price volatility than stocks of larger, more established companies. The Fund may not exactly track the performance of the Index with perfect accuracy at all times. Tracking error may occur because of pricing differences, timing and costs incurred by the fund or during times of heightened market volatility. The Fund relies on the Index provider's methodology in assessing whether a company may be considered a corporate culture leader. There is no guarantee that the construction methodology will accurately assess a company to include or exclude it from the index which could have an adverse effect on the Fund's returns. The Fund's assets may be concentrated in a particular sector or industries to the extent the Index is concentrated and is subject to the risk that economic, political, or other market conditions that have a negative effect on that sector or industry will negatively impact the value of the Fund. The Fund’s assets may be concentrated in a particular sector, industry or group of industries to the extent the Index is so concentrated and could subject the Fund to the risk that economic, political or other conditions that have a negative effect on the Fund. There can be no assurance that the Fund will grow to or maintain an economically viable size, in which case the Board of Trustees may determine to liquidate the Fund.

HAPY: There is no guarantee that the investment objective of the Fund will be achieved. Stock markets are volatile and equity values can decline significantly in response to adverse issuer, political, regulatory, market and economic conditions. The Fund may not exactly track the performance of the Index with perfect accuracy at all times. Tracking error may occur because of pricing differences, timing and costs incurred by the fund or during times of heightened market volatility.

The Fund relies on the Index provider's proprietary scoring methodology in assessing whether a company may be considered a to have a strong corporate culture. There is no guarantee that the construction methodology will accurately assess a company to include or exclude it from the index which could have an adverse effect on the Fund's returns. The Fund's assets may be concentrated in a particular sector or industries to the extent the Index is concentrated and is subject to the risk that economic, political, or other market conditions that have a negative effect on that sector or industry will negatively impact the value of the Fund. Since the Fund may hold foreign securities, it may be subject to greater risks than funds invested only in the U.S.

Companies in the information technology sector can be significantly affected by short product cycles, obsolescence of existing technology, impairment or loss of intellectual property rights, falling prices and profits, competition from new market entrants, government regulation and other factors.

Alpha is a measure of risk (beta)-adjusted return.

Diversification does not assure a profit or protect against loss in a declining market.

Disclosures

The Harbor Human Capital Factor US Large Cap ETF seeks to provide investment results that correspond, before fees and expenses, to the performance of Canadian Imperial Bank of Commerce (“CIBC”) Human Capital Index. The Harbor Human Capital Factor Unconstrained ETF seeks to provide investment results that correspond, before fees and expenses, to the performance of the Human Capital Factor Unconstrained Index. The Harbor Human Capital Factor US Small Cap ETF seeks to provide investment results that correspond, before fees and expenses, to the performance of the Canadian Imperial Bank of Commerce (“CIBC”) Human Capital Small Cap Index.

The CIBC Human Capital Index consists of a modified market-weighted portfolio of the equity securities of U.S. companies identified by Irrational Capital LLC (“Irrational Capital”) as those it believes to possess strong corporate culture based on its proprietary scoring methodology. Constituents eligible are chosen from Solactive GBS United States 500 Index (the “index universe”) at the time of Index reconstitution. The Solactive GBS United States 500 Index intends to track the performance of the largest 500 companies from the US stock market. The index listed is unmanaged and does not reflect fees and expenses and is not available for direct investment. The Harbor Human Capital Factor Unconstrained Index is designed to deliver exposure to equity securities of large cap U.S. companies that demonstrate high employee engagement, based on scores produced by Irrational Capital LLC. The CIBC Human Capital Small Cap Index consists of a modified market capitalization-weighted portfolio of equity securities of approximately 200 U.S. companies identified by Irrational Capital LLC (“Irrational Capital”) as those it believes to possess strong corporate culture based on its proprietary scoring methodology. The Index was developed by the Canadian Imperial Bank of Commerce.

CIBC is a third-party index provider to the Harbor Human Capital Factor U.S. Large Cap ETF and the Harbor Human Capital Factor U.S. Small Cap ETF. Irrational Capital is a third-party index provider to the Harbor Human Captial Factor Unconstrained ETF.

The S&P 500 Index, or Standard & Poor's 500 Index, is a market-capitalization-weighted index of 500 leading publicly traded companies in the U.S. The Russell 1000® Growth Index is an unmanaged index generally representative of the U.S. market for larger capitalization growth stocks. The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. It is a subset of the Russell 3000® and includes approximately 2000 of the smallest securities based on a combination of their market cap and current index membership.

These indices are unmanaged and do not reflect fees and expenses and are not available for direct investment.

The views expressed herein may not be reflective of current opinions, are subject to change without prior notice, and should not be considered investment advice.

Foreside Fund Services, LLC is the Distributor of the Harbor Human Capital Factor Unconstrained ETF, the Harbor Human Capital Factor U.S. Large Cap ETF, and the Harbor Human Capital Factor U.S. Small Cap ETF.

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