Factor investing is an investment style that uses specific attributes to determine the purchase of stocks or bonds. There are two types of factor investing: macroeconomic factors and style factors.
What Is Factor Investing?
Factor investing uses predetermined factors to predict the success of a stock, bond, or fund. There are five investment style factors, including size, value, quality, momentum, and volatility. The other type of factor investing looks at macroeconomic factors such as interest rates, inflation, and credit risk.
The origination of factor investing came in the 1960s with the Capital Asset Pricing Model (CAPM), which said that a stock's expected return is a function of its beta, or correlation to the larger stock market. Factor investing evolved in the 1970s from the Efficient Market Hypothesis (EMH). It was hypothesized that market prices were fair because investors had the same information, reacted instantaneously, and were rational. However, in practicality, there is a wide disparity between access to information, timely reactions, and it can be readily seen that investors don't always act rationally. This means that markets, in practice, don't trade efficiently. This is especially true when there is a relatively high amount of fear or greed felt among investors.
The foundation for factor theory may have been laid in the 1970s but had a breakthrough in 2009 with the publication of the Evaluation of Active Management of the Norwegian Government Pension Fund - Global Report. Experts sought to explain wealth funds' drop in performance during the 2008 financial crisis in this report.
As a result, more investors are using factor investing as a strategy as a way to have a more systematic approach to their portfolio allocation and security selection.
Macroeconomic Factors
Macroeconomic factors are those events and conditions that broadly affect an economy and seek to capture the risk across asset classes. Events can be fiscal, natural, or geopolitical and can affect a region, nation, or the world.
Examples of macroeconomic factors include:
Unemployment rates
Inflation
Interest rates
GDP
Macroeconomic factors are in contrast to the microeconomic factors, which include credit risk, liquidity, and stock price volatility.
Style Factors
Style factors look to explain returns and risk within asset classes. There are five style factors that investors consider when evaluating securities.
The five style factors are:
Size
Value
Quality
Momentum
Risk volatility
How Factor-Based Asset Allocation Investing Works
The goal of factor-based investing is to drive positive stock returns in portfolios. In order to achieve this, investors must evaluate and determine whether or not a security meets the qualification for a buy. Consider the components outlined in the next section when making investing decisions.
5 Factor Investing Components
There are five factor investing components related to the style type of factor investing. Investors should seek securities that pass the test in each category to give themselves the best chances of outperforming the market.
1. Size
A company's size is the first style factor in investing. It says that a small company beats a large company. Small-cap companies are considered those with a market capitalization of up to $2 billion. These small-cap stocks tend to have greater returns than large-cap stocks.
Note: While small-cap stocks have historically achieved greater average returns over time, they do add risk to a portfolio and should be considered thoroughly before investing. There are many experts that argue that the rise in popularity of venture capital funds may have closed the gap between small and large companies.
2. Value
The value style factor says that undervalued companies beat overvalued companies. This means that the company's stock price doesn't factor in potential growth or has a low price compared to its fundamental value. Investors can determine value by examining a stock's price to book value ratio, price to earnings ratio, dividends, and free cash flow.
3. Quality
In this style factor, high capital returns are better than low ones. Investors should be looking for low debt, stable earnings, and consistent growth when examining a stock. These variables can be found by reviewing the debt-to-equity ratio and earnings variability of a company.
4. Momentum
The momentum style factor says that already appreciating stocks should continue to appreciate. In other words, investors should be looking for stocks that have a recent history of performing well. Investors should consider a three-month to one-year time frame when examining past performance in regards to momentum.
5. Risk Volatility
Investors are looking for low-volatility stocks with this style element. Investors can use the standard deviation on a one to three-year time frame to determine volatility betas. A beta higher than 1.0 suggests a stock more volatile than the market, whereas a beta lower than 1.0 is a stock with lower volatility.
Tip: Get the stock's beta by dividing the stock's standard deviation of returns by the market's standard deviation of returns.
Smart 'Beta' & Factor Investing
Smart beta strategies use the rules-based strategies found in factor investing and apply them to an index. ETFs are often used because they are rule-based but cost-effective strategies. In these smart beta investments, all securities in the ETF meet the rules of the style factors. This allows the ETF to try to beat the market that it is designed to follow.
Benefits & Pitfalls of Factor-Based Asset Allocation
As with any investment strategy, there are pros and cons to the method.
Pros of Factor-Based Asset Allocation
Reduced vulnerability to volatility
Systematic approach to investments
Allows for alignment of investment objectives to outcome
Removes emotion from investment
Cons of a Factor-Based Strategy
Many factor funds have not been tested in a bear market
Potential of concentration risk with too much focus on certain factors
Complicated investment strategy
Is Factor Investing Worth It?
Factor investing can complement other investment strategies that an investor has. It diminishes the negative consequences of emotion, helping investors make decisions based on empirical data rather than gut feelings. With factor investing, investors should be able to diversify their portfolios better and generate higher-than-average returns compared to the market. At the same time, they manage risk.
Bottom Line
Investors should consider factor investing as a way to eliminate the emotions out of investing while utilizing a system that focuses on reducing risk and generating better-than-average returns. For investors looking for a diversified portfolio, an ETF following factor investing strategies is an option to consider.
Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
