Updated: Jun 21, 2020
When investors are looking to invest their money in stocks, funds, bonds etc, there are many things to consider. For example, what kind of rate of return are they looking for? How much exposure to risk are they willing to have? What kind of companies do they want to invest in? How will potential macro factors affect the volatility of a certain share price? These are just some of the questions an investor will be asking when stock picking. Ultimately, different investors will have different strategies and philosophies. Some will only invest in large-cap companies, some only in ESG (environmental, social and governance) funds that have a positive economic/social impact, and some in ones that seem completely unfavourable to most other investors. Thus, with so many decisions and factors to take into account, it is easy to understand why there is so much diversity within the investment world. Nevertheless, in this article, I’d like to focus on one particular type of investment style – factor investing.
So…what is factor investing?
Factor investing is an investment approach that targets historically-proven drivers of return among various asset classes. Most commonly known among these are style factors such as value, momentum, size, volatility and quality. However, there are also macroeconomic factors, including inflation, economic growth, and liquidity. Investing in securities that exhibit one, or several of these factors, can help to improve portfolio returns, and protect against unwanted, negative outcomes. Simply put, factor investing provides a way to diversify a portfolio while managing risk and providing market-rate returns.
What are the factors?
There are two types of factors – macroeconomic and style. Within the former category lie economic growth and inflation rate, among others. These macro factors can help to explain returns across asset classes such as equity or bond markets. Style factors help to explain returns within these asset classes. As aforementioned, they include value, momentum, size, volatility and quality. Below, I’ll explain what each of these truly means.
Value: Stocks that are under-priced relative to their fundamentals. Value investing is a strategy that involves selecting stocks that appear to be trading for a lower price than what their intrinsic or book value would suggest that they are worth. It is suggested that value has outperformed growth over time.
Momentum: Stocks with upwards price trends
Minimum Volatility: Stable, lower-risk stocks
Quality: Financially healthy companies with strong fundamentals – high return on equity, low earnings variability, and low leverage (debt-to-equity)
Size: Smaller, higher-growth companies
How does factor investing work?
Fund managers will create factor-specific ETFs, that have screened for their desired factors. After eliminating ones that do not feature the preferred characteristics, investors can then narrow down their search to ones that suit their chosen criteria.
What are the advantages of factor investing vs normal investment?
Factor investing allows investors to build portfolios that better suit their clients’ needs. For example, BlackRock states that “investors looking for downside protection in a volatile market environment might add exposure to minimum volatility strategies to seek reduced risk, while Investors who are comfortable accepting increased risk might look to more return-seeking strategies like momentum.” Factor investment targets specific, proven drivers of return. Eric Walters, President of Silvercrest Wealth Planning argues that “Active managers are trying to guess the market…With factor investing, I decide which factors are important to my clients and I do the research looking for funds where those factors are most robust. It’s more technical than just picking active managers.” Likewise, James Gambaccini, a Managing Partner at Acorn Financial, highlights further advantages of factor investing:
“We determine what factors we need in a client’s portfolio and then screen the entire fund universe for those factors,” Mr. Gabaccini said. “The real advantage is on the risk side, because when markets go down, our portfolios don’t seem to go down as much.”
It seems that factor investing isn’t quite mainstream yet. There are several myths surrounding it, such as that it must be used instead of indexed or active investments. However, factor-based strategies, including Factor ETFs, can be used both to replace and to complement traditional index or active investments in the portfolio. Moreover, many believe that factor and multi-factor investments don’t return the same rate of returns as the broader market. Nevertheless, this is not always the case. For example, the Goldman Sachs Activebeta US LC ETF (GSLC) outperformed the S&P 500 in 2018, returning 21.67%, as opposed to 19.66%. I believe that factor, and in particular, multi-factor investing, is a fantastic way of creating a diversified portfolio, whilst managing risk and obtaining great returns.
If you want to know more about factor investing, click here!
Thanks for reading!