What is factor investing and should you be doing it?

by Jonathan Adams
factor investing

Factor investing is an investment strategy based on breaking down the various ‘factors’ that drive returns across asset classes and building up targeted exposure to these factors. Factors are split into two main groupings:

  • Macroeconomic
  • Style

Examples of macroeconomic factors include inflation, interest rates and economic growth.

Examples of style factors include value, momentum, volatility and size.

Proponents of the approach believe factor investing can help portfolio diversification, reduce volatility and, ultimately, help prove returns.

Factor investing explained

The crux of factor investing is the principle that there are a number of broad but quantifiable factors that can drive or hinder returns common across asset classes from publicly equities, private equity, debt-based securities such as bonds and commodities. By recognising each of these factors, investors can build a portfolio that balances exposure to each, improving diversification and so spreading risk and reducing volatility.

Factor investing is seen by many as a third approach to investing that represents a halfway house between passive investing (tracking indices) and traditional active management (either through personal stock-picking or relying on a fund manager’s picks) based on subjective assessment of which securities will outperform the market – a particular stock market or index.

Factors

Factors are seen as the foundation of a broad-based investment portfolio. Canaccord Genuity compares factors that drive investment returns across asset classes to the nutrients that different foods contain. The same basic nutrients can be found across foods and food groups but in greater concentration in some.

To maintain a healthy diet we have to make sure we get enough of all the nutrients we need and in the correct balance.

How many factors are there?

Investment factors are a subject of academic interest with a number of respected studies on factor investing published on the topic, including the Fama and French’s (1993) 3-factor model and its 5-factor model update, published in 2015, Hou, Xue, and Zhang (2015)’s 4-factor model also referred to as the q-factor model, the Stambaugh and Yuan (2017) 4-factor model, the Barillas and Shanken (2018) 6-factor model, and the Daniel, Hirshleifer, and Sun (2019) 3-factor model.

While as many as 600 investment factors have been defined by academics over the years, the most popular studies simplify this “factor zoo” by boiling it down to usually three to six factors they believe are statistically shown to have the most influence on asset returns.

These are:

  1. Value
  2. Quality
  3. Size
  4. Momentum
  5. Volatility
  6. Market

Plus ‘style’ or company-specific factors.

Is factor investing the same thing as Smart Beta investing?

While it can be argued there are some subtle differences between the factor and Smart Beta approaches to investing the two terms are typically used interchangeably and are based on the same concept – there are a limited number of attributes displayed by assets and asset classes that are the primary drivers of their investment performance.

Factor investing vs the capital asset pricing model (CAPC)

The capital asset pricing model (CAPC) is a methodology for calculating the rate of return an investor should expect from an asset based on its relative risk profile. First set out by William Sharpe in his 1970 book Portfolio Theory and Capital Markets the model is founded on the concept that any individual investment contains two types of risk:

  1. Systematic risk
  2. Unsystematic risk

Systematic risks are market risks that would be called macroeconomic factors in factor investing. They include things like recessions, interest rates and geopolitical events like wars. They cannot be wholly protected against through portfolio diversification.

Unsystematic risks would fall under the ‘style’ group of factors in factor investing and include things like margins, quality of management and innovation. They are factors that influence an asset’s return in a way that isn’t correlated with general market moves.

The idea of CAPC investing is to minimise or mitigate against unsystematic through portfolio diversification. However, on the presumption systematic risk cannot be eliminated, CAPC tries to find ways to reduce it. It does so through a formula that tries to describe the relationship between risk and expected return.

The CACP formula is:

ERi = βi(ERm-Rf)

ERi = Expected return of investment

Rf = Risk-free rate

βi = Beta of the investment

ERm = Expected return of the market

(ERm – Rf) = The market risk premium, which is calculated by subtracting the risk-free rate from the expected return of the investment account. 

The formula’s starting point is a “risk-free rate”, which would apply to an asset like 10-year government bonds issued by countries with the highest credit ratings, such as the USA, Japan, Germany and, at least traditionally, the UK. A premium is then added to the risk-free rate depending on the risk-profile of a particular asset.

That’s calculated differently for different asset classes and sub-classes. In the case of equities, the premium is calculated on the expected overall market return minus the risk-free rate of return.

The problem with a CAPM investing strategy, says a Fidelity overview of factor investing, is that it

“almost by definition, does not deliver excess returns over time; it measures only a stock’s sensitivity to market movement and may instead be a risk factor.”

Why factor investing may help market outperformance

If the CAPM approach is a recipe for matching the market, investors pursuing outperformance must take a different approach. Factor investing advocates say this means seeking exposure to other factors, those that have been shown to lead to long-term outperformance.

The core factors pursued by factor investors have shown an historical tendency to correlate with outperformance. For example, size. In both their 1993 and 2015 studies, Fama and French demonstrated that a return premium exists for investing in smaller-cap stocks.

Factor investors could target the size factor through holding small-cap funds or ETFs that offer a diversified, simple way to “harvest” the small-cap premium. However, it should be kept in mind that small companies are also inherently more volatile and riskier.

Another example would be investing in assets representing the ‘quality’ factor. One popular way to measure quality is to look at the difference between operating cash flow and net income. A 2001 Richard Sloan and Scott Richardson study found that companies with higher earnings quality have also outperformed over time.

There are also numerous studies showing how low volatility can improve investment returns over the long term.

How to practically invest for factors?

The easiest way to align a portfolio to a factor investing strategy is by investing in factor funds or ETFs that either target all the core factors like size, volatility and value, or are focused on one factor. Many of the big fund and ETF providers, for example, Blackrock, iShares, Vanguard and Fidelity offer factor ETFs. You can also look at funds labelled Smart Beta, which take almost exactly ths same approach.



Important
This article is for information purposes only.
Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.
There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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