What Is A Factor In Investing

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Where Does Fbi Fit In Portfolios

What Is Factor Investing & How Does It Work? | The Money Show

FBI can help investors understand the source of returns. Decades of academic research have shown that a number of common security characteristics or factors have historically delivered improved returns relative to market-cap weighted indices over the long term, and FBI strategies allow investors to access these factors. As such, FBI can be viewed as a complement to active or index approaches when seeking specific objectives within a portfolio.

Figure : Examples Of Concepts In The World Of Factor Investing

Meanwhile, others only seem to work over short periods of time, or in a limited number of segments of the market. For example, a study by Campbell Harvey, Yan Liu and Heqing Zhu analyzed over 300 factors and found that most of these factors are likely to be false positives.16 Another recent study by Kewei Hou, Chen Xue and Lu Zhang also found that most anomalies reported in the academic literature failed to hold up when thoroughly tested.17

So what exactly is happening here? The problem is that when researchers analyze many different sets of data, looking for recurring patterns in returns, these patterns are likely to emerge purely by chance and still be statistically significant. So, some caution is needed.

Greater Expected Returns From Factor Investing Historical Premiums

So what kind of premiums are we talking about? Remember, were simply overweighting areas of the market with greater expected returns that have been identified as drivers of portfolio performance, i.e. factors. The positive premiums delivered by these factors have been significant historically. Here are the historical factor premiums for the U.S. from 1963 to 2020:

Remember though that there have also been extended periods where individual factors delivered a negative premium from time to time. For example, the Value premium has suffered in recent years as large cap Growth stocks have dominated the market from roughly 2010 to 2020.

But this is precisely the unexpected outcome. That is, we expect Value to beat Growth on average, but if we have a period like the last decade where the unexpected happens, it would be silly to then place a bet that the unexpected will happen again, i.e. chasing performance by flocking to large cap growth stocks and specifically Big Tech , as many have done in recent years.

In the words of Ken French, the realized return is the expected return plus the unexpected return, and the unexpected return can totally dominate the expected return, almost your complete performance, over any reasonable short-run period. Short-term dominance of the unexpected outcome does not change the long-term expected outcome.

There were virtually zero periods where three or four factors together had negative premiums.

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Factor Models And Criteria

Since the introduction of the Efficient Market Hypothesis , we know the market price should reflect the value of an asset based on all available information. So now the research tends to focus on asset pricing identifying those sources of expected return within efficient markets in the form of independent risk factors outside of market beta. The models that come to mind are those like the Fama French 3 Factor Model. These models are simply attempting to identify which risk factors are empirically relevant to the pricing of assets.

A common saying in statistics is All models are wrong some are useful. What this means is that models by definition are neither perfect nor 100% proven. In that sense, at some point we are choosing to believe, hopefully given robust evidence, that a particular model is reasonably correct enough to dictate or at least influence portfolio construction. Thankfully, loads of evidence heretofore has established the pervasiveness and robustness of the handful of factors well be discussing, and these factors explain about 95% of the differences in returns between diversified portfolios. Any unexplained percentage is necessarily due to luck, skill , or, more likely, some not-yet-identified risk factor.

Lets look at some specific factor models.

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Investors: Why You Should Consider Factor Investing

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What To Look For In A Factor

Actually, it is possible to reduce the number of anomalies included in the zoo down to a handful of truly relevant factors. So, rather than considering hundreds of possible explanations of an assets returns, investors should be selective and focus on a small number of proven factors.

Number of strict requirements

So how exactly should we choose which factors to invest in? To qualify as investable, a factor should meet a number of strict requirements:

Watch Out For Potential Pitfalls

Factor investing isnt an exact science and there are a lot of elements that have to come together to make this strategy a success. Some of these elements are difficult to control, so youre taking a gamble with factor investing.

Because its impossible to dictate what the market will do, even the most carefully crafted portfolio might not yield the returns youre looking for if the conditions arent right. In a bear market, for example, factor-based portfolios arent completely insulated so your investments could fall short of your expectations.

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One other thing to consider is timing. Factor investing is often incorporated into a long-term plan. You can use it to cash in on some gains in the short run, as long as youre aware that you might not be happy with the results.

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Charles Schwab Intelligent Portfolio Smart Beta

The Charles Schwab Intelligent Portfolio Smart Beta ETFs divide into three types: Risk-oriented, Return-oriented, and Other.

Risk-oriented: focuses on low-volatility ETFs and companies with a long track record.

Return-oriented: focuses on momentum factors , quality factors , and fundamental factors .

Other: focuses on equal weight ETFs .

You wont have to pay an additional fee to gain access to Charles Schwabs smart beta but the minimum investment is $5,000. They also offer tax-loss harvesting once you reach the $50,000 threshold.

  • Minimum Investment: $5,000
  • Account Management Fee: $0

How Factor Trading Works

What is factor-based investing?

Here, were going to outline the science of multi-factor investing and the portfolio construction process.

As a starting point, were going to use the equity market.

What happens from here when adopting the factor investing approach?

The first step is to identify and filter out the most volatile stocks.

Why is that?

We want to focus on low-volatility investing, which is one of the building blocks of factor investing.

This will reduce our investment universe and will draw volatility in line with the broader market.

The second step is to withhold only those stocks that score positively on all 3 factors . When these three factors overlap with the same stocks, we can have a nucleus of stocks to include in our portfolio.

Allocating funds to factors such as value, momentum, and quality can help us minimize risk and at the same time increase returns.

Now, youre probably wondering if factor investing works.

The answer to that question will be outlined below:

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What Are The Most Important Factors In Investing

Factor-based investing is rooted in the world of academia, and academics have now identified over 600 factors which may influence risk and return. In reality however, many of these will simply have been used as marketing justification for the launch of a new investment product. There are five style factors commonly accepted as being the most important:

  • Value factors– This is the tendency for stocks that trade at a discount to similar companies based on fundamental valuation measures, such as cash flow or book value, to outperform more expensive assets. Purchasing securities at lower prices could lead to higher returns.
  • Quality factors – High quality stocks, defined by reference to metrics such as strong cash flow or high profitability, will generally outperform lower quality companies.
  • Size factors– Smaller companies in aggregate will, over time, have a tendency to offer a higher return than larger companies.
  • Momentum factors– Stocks which have recently outperformed an index will tend to continue outperforming and vice versa the winners will keep winning, the losers will keep losing.
  • Volatility factors – This describes the propensity for low-volatility stocks to outperform high-volatility stocks on a risk-adjusted basis.

Factor Investing: What Is It And Does It Produce Superior Returns

Nobody likes losing money in the stock market. Theres no way of predicting it, and your earnings can swing wildly from year to year. But what if you could tilt your portfolio in a way to enhance returns? Thats what factor investing attempts to do. But what is it, should it be a part of your financial planning toolkit, and which robo-advisors use it best?

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Our Research Differentiates Msci From The Rest

One of MSCIs key competitive advantages is our research. We employ one of the largest research teams in our industry which contains extensive academic credentials with broad financial and investment industry experience. We are dedicated to building the worlds finest index, portfolio construction and risk management tools working on both developing new factor models and methodologies and enhancing existing ones.

MSCIs rich factor hierarchy is built from the ground-up from aggregated fundamental and technical data. This is based on extensive research to identify common drivers of risk and return and back tested for relevance across markets and investment strategies. Our in-house team of more than 150 researchers blends academic research with practical experience and is continuously innovating to introduce new factors into risk models.

An Example Of Factor Investing In The Real World

Factor investing: cos

Factor investing has grown in popularity over the past decade or so, and financial institutions have developed products to facilitate factor investing. It’s now possible to buy an exchange-traded fund or mutual fund that focuses on a specific factor or a combination of multiple factors.

One example is the Vanguard Small Cap Value ETF. It combines the size and value factors to select stocks that ought to produce market outperformance as a group. It could be used as a counterweight to a total stock market index fund, which is heavily invested in large-cap growth stocks that dominate the market. Consequently, the portfolio is more diversified across factors and should produce better risk-adjusted returns.

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Style Factors And Macroeconomic Factors

Macroeconomic factors capture broad risks across asset classes. Style factors attempt to explain returns and risks within asset classes.

Some of these factors might be asset growth, factor returns, size factors, value factors, risk factors, and leverage factors.

This strategy departs from traditional thinking regarding portfolio diversification in terms of asset classes and portfolio weightings.

As world-class investor Larry Swedroe put it, consider diversification by the exposure to factors that determine the risk and return of a portfolio.

Mr. Swedroes portfolio invests 70% in bonds but due to its factor tilts, still manages to perform exceptionally well against typical portfolios over the long-term.

A lot of academic research has gone into determining which factor strategies are most likely to produce higher returns and limit your overall risk.

Different Robo-advisors choose different factors they think will lead to the best results. The best Robo-advisors throw four or five factors into the mix while some only use a single one.

Some algorithms say companies only using factories to build things produce higher returns than companies that only offer intangible services.

I think Ill invest slightly more in companies with actual factories.

There are dozens of factors you can focus on. You can even choose factors that are outside of potential market returns but line up with your morals.

Final Words Factor Investing

In summary, factor investing is expected to deliver higher returns, but not without assuming a higher risk. Nowadays, factor trading has become popular among hedge fund managers, but this trading style might not be suitable for everyone. Also, be sure to read this article on the best hedge fund trading strategies.

When deciding how to invest the most important factor to consider is whether or not the factor trading strategies suit your personality. If youre a serious investor the evidence shows that the best approach is a combination of passive investing and factor investing, which is also known as evidence-based investing.

When you combine these two very powerful portfolio management strategies, you increase the probability of having a successful investment experience. Check out this guide on ETF trading strategies.

Thank you for reading!

Feel free to leave any comments below, we do read them all and will respond.

Also, please give this strategy a 5 star if you enjoyed it!

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Advantages And Disadvantages Of Factor Investing

One of the most common reasons investors decide to engage in factor investing is because its designed to minimize risk by increasing a portfolios diversity, and if youve spent any time on this site at all youll know that diversification is the key to a successful long-term investment strategy. The reason why factors ensure a diversified portfolio is because the factors cover a wide variety of scenarios and are therefore more likely to perform well at different parts of the economic cycle. So if one factor is currently underperforming, theres a good chance that another factor is doing well as a result.

Factors also minimize risk because they tend to encompass traits that have historically driven high and consistent returns. Since investors can isolate the traits that theyre most interested in pursuing, a smart beta strategy has the potential to maximize returns above market average. Thats why some investors choose a factor-investing strategy as a complement to their traditional index funds, since it helps mitigate exposure on the market and improve the likelihood that portfolios are well-covered during periods of volatility.

Smart Beta And Factor Investing

Factor Investing – Which Factor Outperforms The Market Best?

More recently, other investment approaches have come to the market. This includes index providers who entered the business by offering all kinds of indices designed to benefit from factor premiums. For instance, the MSCI Minimum Volatility index series specifically targets the low-volatility effect, while fundamentally weighted indices provide exposure to the value effect. In this way, factor premiums became alternative betas, or, more popularly, smart betas.

Although investors can passively track smart beta indices, it is important to realize that they are essentially active strategies, because they systematically deviate from the market index and require someone else to be on the other side of the trade. The difference with traditional quantitative strategies is that smart beta indices use a relatively simple and transparent investment approach.

The availability of smart beta indices made it relatively easy for asset owners to consider factor premiums next to traditional classes in their Asset Liability Management or strategic asset allocation process. This is what we call Factor Investing: asset owners allocating strategically to factor premiums next to traditional asset class risk premiums, and essentially treating both as equal.

âThere is no single optimal factor allocationâ

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Figure : Historical Performance Of Proven Credit Factors

These graphs show that stocks featuring attractive value, momentum and quality factor characteristics achieve higher returns over the longer term. In the credit space this holds true for corporate bonds with attractive value, momentum and size factor characteristics. Investors can either focus on each one of these factors independently or target a combination of factors for more stable outperformance over time.

Cons Of Factor Investing

Factors are not completely risk free and not being aware of these risks can lead to under preparedness in the trading journey. First and foremost, one must take into account how sometimes a factor may be seen only from the perspective of benefits in return and not the errors associated with it.

For example, a stocks performance might have been good over the past two years in case of momentum. But, it is also possible that the stock had been seeing a downfall for more than 6-7 years earlier.

Before deciding your investment approach, you must weigh both the benefits and the errors it may lead to. After weighing both, you can get a near to accurate estimate of risks and returns of investing on the basis of that factor.

And perhaps most dangerous of all, factor investing presents the risk of data mining. Only factors that show good backtest results are shown. This bias is known as selection bias. A factors historical record being randomly good/accurate can lead to wrong decision making.

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