What is factor investing?
Are there ingredients that can predict the success of an investment? Factor investing is based on the idea that it is possible to rely on data to achieve higher returns. Naturally, these returns are not guaranteed, but it is worth taking a closer look at this growing approach.
What is factor investing?
Factor investing is an investment strategy that focuses on identifying and exploiting certain “factors” or specific characteristics of investments that have historically demonstrated superior risk-adjusted returns. César Muro, Head of Passive Distribution in Iberia for DWS, defines a factor as “a series of specific characteristics of a group of securities that are statistically significant in explaining their returns and risks.”
Thus, instead of focusing on individual stock selection or sector diversification, investors using this strategy build their portfolios by selecting assets with certain characteristics associated with long-term profitability.
Origins of factor investing
Factor investing began in the 1960s with the Capital Asset Pricing Model (CAPM). This model held that there was one factor influencing stock returns, and that a stock’s expected return depended on its volatility, quantified as beta. However, in the 1970s, a more robust candidate for an investment factor emerged: value.
The value factor—behind value investing, which we have already discussed on the blog—is based on the premise that stocks undervalued by the market tend to offer superior long-term returns. We have also discussed the margin of safety on the blog. As Benjamin Graham, who coined this concept, said, “Price is what you pay; value is what you get.” So if we buy a stock whose value exceeds its price, we are buying an undervalued stock: the difference between value and price will be the margin of safety. And the value of the stock ultimately depends on the money-generating capacity of the company behind it.
In the 1990s and 2010s, academics like Eugene Fama and Kenneth French added some more factors to the list, such as momentum, size, or quality. However, it was not until 2009 that factor investing gained definitive momentum. That was when a group of academics was commissioned to study the returns achieved by their stock portfolio. After isolating several of them, the creation of indexes exposed to these factors was suggested to achieve better results.
Investment factors
There are two main categories of factors. On the one hand, there are macroeconomic factors, which include elements like inflation, interest rates, and economic growth—difficult to predict. On the other hand, there are style factors, that is, specific characteristics of assets that make them likely to achieve superior returns.
Fernando Luque, editor at Morningstar.es, indicates that there is broad academic consensus “in identifying six sources or factors of profitability: value, momentum, size, volatility, quality, and dividends.”
Value
The value factor is based on the premise that “cheap stocks based on their market price relative to their book value perform better in the long term,” as noted by César Muro. This idea, as we know, comes from Benjamin Graham and his student Warren Buffett.
Momentum
Momentum refers to the tendency of stocks that have performed well in the recent past to continue that trend in the near future. This factor is based on the idea that market trends, once established, tend to persist for a time before reversing.
Size
The size factor refers to the tendency of small-cap stocks to outperform large-cap stocks over time. Although small companies may be more volatile, they also have greater growth potential, which can translate into higher returns.
Volatility
Stocks with lower volatility tend to offer higher risk-adjusted returns. Although this factor may seem counterintuitive (since it is assumed that higher risk should yield higher returns), studies have shown that low-volatility stocks often outperform high-volatility stocks in the long run.
Quality
The quality factor focuses on identifying companies with strong financial characteristics, such as high profitability, low debt, and stable cash flows. High-quality companies tend to be more resilient in times of economic uncertainty and, therefore, offer more attractive risk-adjusted returns.
Dividends
The dividend yield factor is a key element that refers to the tendency of stocks with high dividends to provide superior risk-adjusted returns. Dividend yield is calculated by dividing a stock’s annual dividend by its current price, expressed as a percentage.
Thus, factor investing offers a data-driven strategy to identify and exploit specific characteristics that have been shown to offer superior risk-adjusted returns. While this strategy can offer significant advantages, it also requires a disciplined approach and a deep understanding of the factors involved. For investors willing to dedicate the necessary time and resources, factor investing can be a powerful tool in the pursuit of long-term profitability.