What Is Factor Investing?
By Bill Addiss | June 27, 2019
Factor investing recognizes that the price of a stock can be subject to many factors. Some of these may be macroeconomic variables like inflation, interest rates, strength of the economy, etc. Other factors may be more specific to the stock itself. In analyzing these factors, there are a number of common features that can be identified in the stocks that tend to outperform the market. The goal of factor investing is to use these common factors to identify stocks which should outperform over the long term. In the jargon of the market, this outperformance is called alpha. Factor investing provides a rule based approach to achieving alpha.
The 5 Most Universally Recognized Factors in Factor Investing
- Value: Value investing suggests that inexpensive or undervalued stocks should outperform more overvalued ones. Most factor based investors would agree that the value feature is certainly the most important consideration to take into account, and a broad array of empirical studies bear this out. Simply put, investors want to buy undervalued assets, and sell overvalued assets. This concept is certainly not new or unique to Factor investing. Highlighted in the groundbreaking book Securities Analysis by Graham and Dodd, first published in 1934, they urged long term investors to buy stocks at a discount to their intrinsic value.
- Size: Studies clearly show that a return premium exists for investing in smaller-cap stocks. This could be due to their inherently riskier nature, because smaller companies are typically more volatile and have a higher risk of bankruptcy. For this reason, investors expect to be compensated for taking on that additional level of risk. Others speculate that it could be because smaller companies are often overlooked by analysts and are more illiquid, therefore investors need to be compensated for these risks. Whatever the reason, there is strong evidence that smaller companies outperform large companies over a longer time period.
- Momentum: The concept of momentum investing is similar in spirit to what technical analysts have been doing for decades, namely, examining stock price trends to forecast future returns. In studies that go back to the 1930s it has been demonstrated that stocks that had outperformed in the medium term would continue to perform well, and vice versa for stocks that had underperformed the market. This can also be attributed to what some call the herd mentality or behavioral science, which has shown that investors are more likely to buy those stocks which have most recently moved up, and less likely to buy those that have gone down.
- Quality: Although investors have been seeking out high-quality companies for decades, empirical evidence validating the merits of this approach has only recently emerged. Part of the problem here is a lack of consensus on how best to define quality. Many observers agree, however, that higher profitability, more stable income and cash flows and a lack of excessive leverage are hallmarks of quality companies. Quality should not be confused with size. Quality usually refers to issues such as stable cash flow, low debt/equity margins, growing profit margins, consistent asset growth and strong corporate governance. Unfortunately, some areas of quality also tend to be more subjective, such as reputation, the value of a brand or ethically and socially responsible activities.
- Low Volatility: As the name suggests, the primary objective of a low volatility approach is to own stocks that have lower risk or price volatility than the broader market. Considerable research has shown that on a risk adjusted basis, low-volatility portfolios may also outperform the broader market over time. The important point here is that this refers to risk adjusted returns, not absolute returns. Return should always be measured in connection with risk. It does not make sense for an investor to take on a huge amount of risk for only a minor increase in their rate of return. Ideally, an investor would want an incrementally higher rate of return relative to the additional risk they may be taking on. Price volatility of a stock is certainly one of those risks.
As the illustration below highlights, the concept of factor investing actually bridges the world between passive investing, where an investor is trying to mimic the return of an index, (beta) and purely active investing where the goal is to select a portfolio constructed of just those stocks that will hopefully outperform the market (alpha).
Until recently, factor investing was really only used by institutional investors. Very few individuals had the expertise and resources to identify these opportunities. Certain components, like value investing and small cap investing have been staples of active management for decades. However, over the last decade mutual fund families have recognized that factor investing and factor rules based considerations could be offered to the retail investors in the form of mutual funds. Today, these funds go by a number of names – factor funds, alternative beta, smart beta, fundamental indexing, etc. As the chart below highlights, there are a number of mutual fund companies offering funds based on these principals.
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