What is Factor Investing?
Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.
Some common macroeconomic factors include: the rate of inflation; GDP growth; and the unemployment rate. Microeconomic factors include: a company’s credit; its share liquidity; and stock price volatility. Style factors encompass growth versus value stocks; market capitalization; and industry sector.
History of Factor Investing
Factor investing originated from the Capital Asset Pricing Model (CAPM), a theory that strived to explain an asset’s returns relative to its sensitivity to market risk.
Although the CAPM helped provide a framework for pricing assets, empirical research provided evidence that stock market returns did not exactly follow the model’s framework. Instead, there was evidence that stock market returns were correlated to the stock’s characteristics.
One of the earliest observations was that the size of a company’s market capitalization is an important consideration for investors. Small-cap stocks usually perform better than large-cap stocks, which explains the performance of stock returns that deviates away from the explanations provided by the CAPM.
Foundations of Factor Investing
Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.
Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.
Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame.
Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by using common financial metrics like a return to equity, debt to equity and earnings variability.
Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one- to three-year time frame is a common method of capturing beta.
Advantages of Factor Investing
Factor investing provides the benefits of diversification, which minimizes a portfolio’s exposure to risk. Factors can improve diversification because style and macroeconomic factors cover various situations in the economic cycle.
Factor investing is also associated with the benefits of high returns because the strategy follows a stock’s traits that have historically generated positive earnings. For example, empirical evidence suggests that following a quality-based factor investing approach generates positive returns, as investors put their money in financially healthy companies.
Therefore, investing in assets that use the factor investing approach can help enhance returns, reduce risk, and improve diversification.
Disadvantages of Factor Investing
A disadvantage of factor investing is that investors may accidentally be exposing themselves to additional risk instead of minimizing risks.
For example, investors who are approaching their investing strategy using the size factor may be putting too much weight on small-cap stocks, exposing them to risks associated with investing in small, high-growth companies. Additionally, using only one factor as your investment strategy imposes many risks.