What Exactly Is Factor Investing?
A technique known as factor investing selects stocks based on characteristics linked to increased returns. Macroeconomic and style factors are the two main categories of factors that have influenced stock, bond, and other factor returns. While the latter seeks to explain returns and risks within asset classes, the former covers broad risks across asset classes.
Typical macroeconomic variables are the unemployment rate, GDP growth, and inflation rate. A company’s creditworthiness, share liquidity, and stock price volatility are examples of microeconomic factors. Style determinants include the industrial sector, market capitalization, and growth versus value stocks.
Factor Investing: What You Need to Know
Theoretically, factor investing aims to increase diversification, produce returns above the market, and control risk. Diversifying a portfolio has long been seen as a safe strategy, but its benefits are nullified if the selected stocks follow the same direction as the market as a whole. An investor might, for instance, like a mix of bonds and equities, all of which experience value declines under specific market circumstances. The good news is that by focusing on broad, enduring, and well-established sources of returns, factor investing can mitigate potential dangers.
Given the number of factors available, factor investing may appear overwhelming, especially considering how simple it is to apply classic portfolio allocations such as 60% equities and 40% bonds. Novices in factor investing can concentrate on more basic components like style (growth vs. value), size (large cap vs. small cap), and risk (beta) instead of more intricate characteristics like momentum. Most securities have these characteristics available to the public and are listed on well-known stock research websites.
Bases of Factor Investing Management
Value investing seeks to profit from stocks undervalued for their inherent worth by capturing excess returns. Price to book, price to earnings, dividends, and free cash flow are often used metrics to track this.
Small-cap stock portfolios have historically outperformed large-cap stock portfolios in terms of returns. A stock’s market capitalization might give investors an idea of its magnitude.
Previous high performers’ stocks typically show robust returns in the future. The foundation of a momentum strategy is based on relative returns over three months to one year.
Low debt, steady earnings, steady asset growth, and robust corporate governance are quality characteristics. Investors can use common financial indicators such as return on equity, equity debt, and earnings variability to find high-quality stocks.
According to empirical research, equities with low volatility outperform highly volatile assets in terms of risk-adjusted returns. One popular way to measure beta is to take standard deviation measurements over one to three years.
The Fama-French 3-Factor Model, for Instance
The Fama and French three-factor model, which builds upon the capital asset pricing model (CAPM), is one popular multi-factor model. Eugene Fama and Kenneth French, two economists, made the Fama and French model using its three components—firm size, book-to-market values, and excess return on the market. SMB (small minus extensive), HML (high minus low), and the portfolio’s return less the risk-free rate of return is the three factors used in the model. HML accounts for value equities with high book-to-market ratios that outperform the market, whereas SMB accounts for publicly traded companies with smaller market caps that produce higher returns.
- Factor investing makes use of a variety of factors, such as fundamental, statistical, and macroeconomic ones, to assess and explain asset values and develop investment strategies.
- Investors have identified several factors, including growth vs. value, market size, credit rating, and stock price volatility.
- One widespread use of a factor investing method is smart beta.