What is Factor Investing?

An investment strategy known as factor investing entails focusing on particular sources of returns across financial assets. Factor investing can help increase diversification, lower volatility, and improve portfolio results.

The basis of investing is factors; they are broad, consistent drivers of performance across financial assets. An investors may better exploit factors' potential for increased return and lower risk by understanding how they operate.

Factor investing work Explained

Theoretically, factor investing is intended to increase diversification, generate high returns, and manage risks. Diversifying a portfolio is a well-known safety measure, but if the selected assets move in synch with the overall market, the benefits of diversity are lost. An investor might, for instance, select a combination of equities and bonds which all experience value declines when specific market conditions occur. The best part is that by focusing on large, consistent, and well-established return drivers, factor investing can reduce possible dangers.

With the variety of factors available, factor investing may appear daunting given the ease with which conventional portfolio allocations, such as 60% equities and 40% bonds, may be implemented.

Factor investing includes selecting stocks based on specific attributes that, historically, have outperformed the overall market on a risk-adjusted basis. Its target is to explain outperformance that deviates from the efficient market hypothesis and capital asset pricing model.

Investors can construct a diversified portfolio that provides superior risk-adjusted returns than the overall market by basing their investments on certain characteristics and mixing approaches. Factor investing thus offers a substitute for passive investment in market index funds.

Classes of factors

Macroeconomic and stylistic factors are the two basic classes.

Macroeconomic factors encompass broad risks across financial assets, and style factors, serve to interpret returns and risk across assets.

Value, size, volatility, momentum, and quality are the five investment style factors typically used to choose individual stocks in this manner. Macroeconomic variables including interest rates, economic growth, credit risk, liquidity, and inflation are also used in factor investing to diversify holdings across various assets and geographical regions.

It is crucial to remember that the factors are predicted to beat the general market mostly in the long run. These factors has seen lengthier stretches in the past where they underperformed the market as a whole or even experienced large downturns. Managers attempt to circumvent this by diversifying their factors and building their portfolios utilizing macroeconomic factors. This strategy is referred to as smart beta investing.

The volatility of a stock price in proportion to the market as a whole is measured by its beta. A stock's beta value of 2.0 indicates that it moves two percentage points per each percentage point the general market does.

Beta, however, has been determined to be insufficient to account for overall market performance. Because the stock market often increases in value over the long run, stocks having a high beta should hypothetically outperform over time. A 1970s study by Robert A. Haugen and A. James Heins revealed less volatile equities—those with a lower beta—performed better in the long run than more volatile stocks.

A few other factors, such as dividend yield and trading, that are less reliable and don't have so much impact on returns, are also occasionally included.

Value

Initially, the price/book ratio of equities served as the foundation for the value factor. The majority of factor funds now combine various ratios, including price/book and price/earnings, as a result of how this has changed over the years. A few funds may create their own unique measurements of value to gain a competitive edge. For example, s tocks that are abandoned for a brief time will eventually become overvalued or appropriately valued.

Size

This factor asserts that smaller is better. As a result, stocks of smaller companies have higher returns than those of larger companies. Small-cap equities are the main focus of funds with this factor. Stocks classified as small-caps have a market value of $300 million to $2 billion. Typically, small-cap companies are riskier because they are less established compared to more established large-cap companies.

Volatility

The volatility of a stock is compared to the volatility of the market to calculate its beta. If a stock, for instance, has a beta of 1.50 and the market increases by 10%, the stock is predicted to increase by 15%. 

High risk is generally gauged by volatility. Due to the minimal risk associated with lower volatility stocks, they tend to outperform the market. The low-volatility factor can be used by many investors to diversify their portfolio. Investing based on the small-size factor, which carries more risk, can still outperform with the low-vol factor amid bad markets because low volatility factor tends to outperform in bear markets.

Momentum

The top quintile or quartile of stocks with the best returns are selected and used to measure momentum. Because investors prefer to inject their money in more of the companies that are steadily growing, momentum, or trend-following, works.

Quality

Quality performs better since it often lasts a long time. Maintaining high profitability while growing a business to generate billions of dollars or more in revenue, provides some form of competitive edge for the investor.

Origin of factor investing

The Capital Asset Pricing Model (CAPM), which was created in the early 1960s, is where factor investing first appeared. The CAPM suggested that the market was the primary factor for all equities. The Fama-French model came next, demonstrating that returns are also influenced by size and value. Researchers eventually discovered the additional elements and demonstrated how they might produce extra returns.

SMB (small minus big), HML (high minus low), and the return on the portfolio less the risk-free rate of return are the three variables employed in the model. While HML accounts for value equities with high book-to-market ratios that produce higher returns than the market, SMB measures publicly traded companies with modest market caps that produce higher returns.

Factors have become the focus of numerous mutual funds and exchange-traded funds (ETFs). For example, ETFs virtually all have extremely low expense ratios since they are passively managed.