Factor-Based Investing

What is “Factor-Based Investing”?

Factor-based investing targets securities that demonstrate specific, quantifiable drivers for return and risk that can be grouped as different “factors”. The main objective of factor-based investing is to enhance overall performance and reduce the risk in a portfolio by either allocating to or avoiding certain factors. This approach is considered to sit between traditional active management and index investing and is most commonly adopted by smart beta strategies.

History of Factor Investing

Factor-based investing has become very popular among both institutional and retail investor mainly for one reason – over the long-term, indices constructed purely on factor characteristics tend to outperform the traditional indices which have been built only with reference to market capitalization.

This investment style began in the late 1970s and was developed from the capital asset pricing model (CAPM). The theory was that identifying factors or qualities that differentiated assets and individual investments could lead to outperforming the market.

Factors in Investing

Factor investing involves the selection of securities according to pre-identified attributes called “factors.” The main objective is to enhance total returns and reduce risk by either capturing or avoiding certain factors. There are hundreds of different factors, but the main five that are commonly accepted are Value, Size, Quality, Momentum, and Volatility.

Click here to download the free Financial Edge template to access data and charts comparing the FTSE100 to each of these five factors over the past 15 years.

Investment Factors

Today five main factors are most commonly recognized by both investors and academia. Each of these factors is an attribute that investors associate with higher returns.

Value

The Value factor targets the above market returns from stocks that are trading below their intrinsic value. Some of the measures that are used to identify these companies are ratios such as price to earnings, price to book, price to sales, and price to free cash flow.

Size

The size factor relies on the assumption that portfolios invested in companies with smaller market capitalization have the potential to deliver higher returns compared to portfolios invested only in large-cap stocks. By only investing in smaller-sized companies (or companies below a certain size) then investors can aim to capture this factor.

Momentum

The momentum factor argues that stocks that have historically delivered higher returns than those offered by the market tend to have a strong performance profile going forward and vice versa. The theory is that stocks that have recently outperformed the market will continue to do so and should be invested in. This strategy is based on relative returns over the short-term, usually up to a one-year period.

Quality

The quality factor aims to identify companies with low debt levels, consistent earnings and growth, diversified business model and strong management. Typically, these companies are assessed using various measures such as debt-to-equity ratios, earnings variability, and need to demonstrate high profitability and strong cash flow generation abilities. Once parameters have been set on these metrics, investors can select companies that are deemed ‘quality’ and create a portfolio.

Volatility

The volatility factor suggests that companies with a lower-risk profile measured by volatility will typically outperform those with higher volatility on a risk-adjusted basis. The specific time frame for this assumption varies, but usually three years is a common period for measuring the overall market risk. Volatility is typically measured by standard deviation, and investors are seeking beta.

Smart Beta Investing

Smart beta is a type of factor investing that uses broad and persistent drivers of return. This is derived from the capital asset pricing model (CAPM) and is designed to combine the attractiveness of passive investing with additional active investing strategies. Typically, these funds will create indices based on factors other than just traditional market cap parameters. Smart beta strategies may include selecting stocks based on volatility, momentum and other factors such as size or quality.

Macroeconomic Factors

Factor investing includes macro factors affecting multiple asset classes and style factors within a single class, implemented with or without leverage.

Style Factors

Smart beta usually involves style factors within one asset class, implemented without leverage, often in long-only, index-based strategies like ETFs.

Quantitative Investing Strategies

Quantitative investing, often called systematic investing, emphasizes data-driven insights, scientific testing of investment ideas, and advanced computer modeling techniques to construct portfolios. This approach leverages the power of big data, data science, and deep human expertise to modernize the way we invest.

Market-Cap Weighted Indices

Market-cap weighted indices, such as the large global ones like FTSE World, consist mainly of stocks with higher valuation metrics. These stocks tend to receive a larger weighting compared to those with lower valuation metrics. As a result, the index could be dominated by just a few large, overvalued companies, whose share prices are high relative to their fundamentals.

Factor Based Investing vs Traditional Indices

The main reason for the popularity of factor-based investing is its ability to outperform traditional indices over the long term. Traditional indices, which are based on market capitalization, often include stocks with higher valuation metrics, leading to a concentration of a few large, potentially overvalued companies. Factor-based investing, on the other hand, targets specific, quantifiable drivers for return and risk, aiming to enhance overall performance and reduce risk in a portfolio.

Pros and Cons of Factor Investing

Here are some of the Pros and Cons of factor-based investing:

Pros

Factor investing has the ability to outperform traditional indices over the long term and targets specific, quantifiable drivers for return and risk. It aims to enhance overall performance and reduce risk in a portfolio.

Factor investing allows investors to target broad, persistent, and recognized drivers of returns, which can help enhance diversification in a portfolio. By strategically choosing securities based on attributes associated with higher returns, factor investing can potentially generate above-market returns.

Factor investing uses a systematic approach that removes emotion from the decision-making process, which can lead to more consistent investment outcomes. It provides more portfolio customization than purely passive investing, allowing investors to tailor their portfolios to specific risk and return objectives

Cons

There are, however, some downsides to factor-based investing. Firstly, traditional indices often include stocks with higher valuation metrics and a concentration of a few large, potentially overvalued companies.

Factor investing can be complex and requires a deep understanding of the factors and how they interact with each other. Investors need to continuously monitor and adjust their portfolios to ensure they are capturing the desired factors and avoiding unwanted risks

While factor investing can enhance returns, there is also the potential for underperformance if the chosen factors do not perform as expected

Conclusion

Factor-based investing offers a compelling alternative to traditional investment strategies, providing opportunities for enhanced diversification, above-market returns, and portfolio customization.

As with any investment strategy, it is crucial for investors to thoroughly understand the factors they are targeting and to remain vigilant in managing their portfolios to capture the desired benefits.

Additional Resources

Portfolio Management Course

Active vs Passive Investing

Growth Investing

Gals Based Investing