December 15, 2020
Factor-investing distills investment strategies down to their unique characteristics in order to target specific risk and return profiles. Investors can essentially pick and choose between specific factors in an attempt to generate long-term investment returns in excess of benchmarks. They can benefit from diversification and personalization, but may have to pay excess fees in order to be able to direct their portfolio.
Factor based investing is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation. However, it’s important to remember that nothing – not even historically accurate factors – can certainly predict future returns. If you’re interested in learning about this investing approach, keep reading below:
You might’ve heard of the phrase “value investor,’ or its opposite “growth investor.” The value factor strategy is geared towards investing in stocks that are priced at a discount compared to their fundamental value. Fundamental value is often calculated by metrics like price to book, price to earnings, dividends, and free cash flow. These are then either compared against a benchmark or other competitors in the same industry.
The size factor is all about investing in small-cap stocks rather than portfolios with just large-cap stocks. Historically, companies with a smaller market cap perform better than large-cap companies. Market cap refers to the % of the consumer market that the company serves.
Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy usually looks at returns from a 3 to 12-month time horizon.
The quality factor focuses on companies that have low debt, stable earnings, consistent growth, and usually a good dividend history. These are usually banks or well-established companies in the mature stage of the business cycle.
Hard to believe in our currently volatile market, but historically stocks with low volatility earn greater risk-adjusted returns than highly volatile equities.
Like most other investment strategies, factor investing grew popular as a way to enhance portfolio diversification and generate above-average returns while managing risk. Factor investing has been shown to offer some benefits in the past:
Factor-based investing – especially if focused on making above average returns – tends to be more expensive than investing in traditional index funds. As factor-based investing becomes more popular and mainstream, the investment returns may be distorted by a ‘desirability factor.’ This not only inflates short term returns, but also means that prices for factor-based funds are higher than ever.
Additionally, investors may underestimate how much their factor-based portfolio is actually correlated with the market. In other words, investors may miss out on a well-balanced portfolio by focusing too much on a certain number of factors. The chance of higher risks is even greater if the factors you’re focusing on emphasize above-average returns. The cardinal “high reward/high risk” stock market rule is as true here as it is everywhere else.
Factor investing offers investors more options and control over their portfolios. It’s largely based on observable trends in the past and offers a guideline for future expectations. However, depending on how the strategy is implemented, factor-based investing can have some drawbacks. It can be more expensive than index-based investing, and risk-adjusted returns may not be much higher than passive investing. Depending on what factors you focus on, your investments can go through periods of low performance. If you choose to sell your investments at that point, you may be charged high fees for none of the reward.