Factor investing is a strategy that chooses securities based on attributes associated with higher returns. There are two main types of factors driving returns for stocks, bonds, and other assets: macroeconomic factors and style factors. The former captures broad risks across asset classes, while the latter aims to explain returns and risks within each asset class.
Some common macroeconomic factors include: the rate of inflation, GDP growth, and the unemployment rate. Microeconomic factors cover aspects such as a company’s credit score, share liquidity, and stock price volatility. Style factors involve growth versus value stocks, market capitalization, and industry sectors.
Key Takeaways
- Factor investing utilizes multiple factors, including macroeconomic as well as fundamental and statistical elements, to analyze and explain asset prices and build investment strategies.
- Common factors identified by investors include growth vs. value, market capitalization, credit rating, and stock price volatility, among others.
- Smart beta is a widely used application of a factor investing strategy.
Elevating Your Portfolio with Factor Investing
Factor investing is designed to enhance diversification, generate above-market returns, and manage risk. Traditional portfolio diversification, while a safety tactic, can fall short if chosen securities move in sync with the broader market. Factor investing counters this by targeting long-recognized drivers of returns that operate independently.
While traditional portfolio allocations like 60% stocks and 40% bonds are straightforward, factor investing can feel overwhelming due to the myriad of potential factors. Beginners can start with simpler attributes, such as style (growth vs. value), size (large-cap vs. small-cap), and risk (beta). These are available on popular stock research websites.
Foundations of Factor Investing
Value
Value aims to capture excess returns from stocks priced lower relative to their fundamental value, typically tracked by metrics like price-to-book, price-to-earnings ratios, dividends, and free cash flow.
Size
Portfolios focusing on small-cap stocks historically show greater returns than those with large-cap stocks. Investors can capture the size factor by evaluating the market capitalization of a stock.
Momentum
Stocks that have performed well in the past often continue to do so in the future. A momentum strategy is based on relative returns over time frames ranging from three months to one year.
Quality
Quality is defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks using financial metrics like return on equity, debt to equity, and earnings variability.
Volatility
Research suggests that stocks with low volatility earn better risk-adjusted returns than highly volatile ones. Measuring standard deviations over one to three years is a common way to gauge beta.
Example: The Fama-French 3-Factor Model
One widely used multi-factor model is the Fama and French three-factor model, which expands on the capital asset pricing model (CAPM). Created by economists Eugene Fama and Kenneth French, the model uses three factors: the size of firms, book-to-market values, and excess market return. In this model, the factors used are SMB (small minus big) and HML (high minus low), with the portfolio’s return also considered minus the risk-free rate of return. SMB focuses on small-cap companies that generate higher returns, whereas HML targets value stocks with high book-to-market ratios generating higher returns compared to the market.
Related Terms: Macroeconomic Factors, Style Factors, Portfolio Diversification, Smart Beta.
References
- MSCI. “Factor Focus: Value”. Page 2.
- MSCI. “Factor Focus: Size”. Page 2.
- MSCI. “Factor Focus: Momentum”. Page 2.
- MSCI. “Factor Focus: Quality”. Page 2.
- S&P Dow Jones Indices. “Low Volatility: A Practitioner’s Guide”. Pages 1-2.
- Fama, Eugene F. and French, Kenneth R. “Multifactor Explanations of Asset Pricing Anomalies”. The Journal of Finance, vol. 51, no. 1, March 1996, pp. 55-84.
