What is Factor Investing?
The term “factor investing” refers to a method of picking stocks based on criteria that tend to lead to higher profits. Returns on stocks, bonds, and other investments can be broken down into two broad categories: macroeconomic factors and style considerations.
In contrast to the former, which attempts to explain returns and risks across asset classes, the latter focuses solely on those that exist inside individual asset classes.
Inflation, GDP growth, and the unemployment rate are all examples of macroeconomic variables. Company credit, share liquidity, and stock price volatility are all examples of microeconomic factors. Style considerations include growth vs. value stocks, market cap, and business sector.
KEY POINTS
- To assess and explain asset prices and develop an investment plan, “factor investing” takes into account a wide range of elements, not just macroeconomic ones but also fundamental and statistical ones.
- Many factors, such as growth vs value, market size, credit rating, and stock price volatility, have been recognized by investors.
- A frequent implementation of factor investing, smart beta is gaining popularity.
The Basics of Factor Investing
Theoretically, factor investing should help investors diversify their portfolios, earn superior returns, and control their exposure to risk.
Although diversifying one’s portfolio has long been seen as a prudent strategy, it becomes counterproductive if one’s chosen securities follow the market’s every move.
An investor can choose a portfolio consisting of stocks and bonds that all fall in value when a particular event occurs in the market. The good news is that factor investing can mitigate dangers by focusing on widespread and enduring factors that have long been known to influence outcomes.
The sheer variety of parameters available for investing might be daunting in comparison to the simplicity of more standard portfolio allocations like 60% stocks and 40% bonds.
Start with the basics: style (growth vs. value), size (large cap vs. small cap), and risk, rather than more advanced concepts like momentum, while you’re just getting started in factor investing (beta).
Most securities have these characteristics easily available, as they are typically mentioned on prominent stock research websites.
Strategies for Success in Factor Investing
Value
Value strategy is to profit from equities that are undervalued compared to their potential earnings. Prices relative to book value, earnings, dividends, and free cash flow are frequently used to monitor this.
Size
Portfolios that include small-cap equities have historically outperformed those that only included large-cap stocks. The market capitalization of a company gives investors a sense of its scale.
Momentum
Strong returns are typically displayed by stocks that have outperformed in the past in the future. Momentum investing is predicated on comparative returns over a time period of three months to one year.
Quality consists of few liabilities, steady profits, expanding assets, and sound management practices. Return on equity, debt to equity, and earnings variability are three common financial metrics used by investors to identify high-quality firms.
Volatility
In terms of risk-adjusted returns, studies show that low-volatility stocks perform better than more volatile assets. Common methods of obtaining beta include measuring standard deviation over a one to three year time period.
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Instance: The Fema-French 3-Factor Model
The Fama and French three-factor model is a popular example of a multi-factor model that extends the CAPM (CAPM). Economists Eugene Fama and Kenneth French developed the Fama and French model, which takes into account business size, book-to-market valuations, and excess return on the market.
In the language of the model, these three variables are referred to as SMB (small minus large), HML (high minus low), and the return on the portfolio minus the risk free rate of return.
Stocks with high book-to-market ratios (HML) and small-cap stocks (SMB) are two types of publicly traded corporations that have historically outperformed the market.
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