History Of Factor Investing
Factor investing originated from the Capital Asset Pricing Model , a theory that strived to explain an assets returns relative to its sensitivity to market risk. Although the CAPM helped provide a framework for pricing assets, empirical research provided evidence that stock market returns did not exactly follow the models framework. Instead, there was evidence that stock market returns were correlated to the stocks characteristics.
One of the earliest observations was that the size of a companys market capitalization is an important consideration for investors. Small-cap stocks usually perform better than large-cap stocks, which explains the performance of stock returns that deviates away from the explanations provided by the CAPM.
Advantages Of Factor Investing
Factor investing provides the benefits of diversification, which minimizes a portfolios exposure to risk. Factors can improve diversification because style and macroeconomic factors cover various situations in the economic cycle.
Factor investing is also associated with the benefits of high returns because the strategy follows a stocks traits that have historically generated positive earnings. For example, empirical evidence suggests that following a quality-based factor investing approach generates positive returns, as investors put their money in financially healthy companies.
Therefore, investing in assets that use the factor investing approach can help enhance returns, reduce risk, and improve diversification.
The Cyclicality Of Factor Performance
The evidence has proven that using these key factor exposures can result in significant results to your portfolio. That said, there isnt one factor that works every time, and the returns can be cyclical.
For example, small-caps can underperform large-caps for multi-year periods, in the same way they did during the late 1990s technology bubble, and the 2008-08 financial crisis.
When value stocks plummeted in the midst of the high-growth tech bubble they succeeded in earning back their losses afterwards. When the market changes in direction quickly it is usually at the detriment to momentum strategies like the collapse of the tech bubble in 2000, and after the bounce back from the financial crisis
Generally, quality portfolios perform lower during low-quality rallies such as in 2003 when the beaten down stocks drove the market to rebound. Lastly, bear markets, like the one in 2009, generally lead to low-volatility stocks underperforming.
Investors might find these performance swings unnerving, resulting in them selling and missing on the gains on the rebound. Overall, factors are not really correlated with each other they are affected by distinct market anomalies and, as a result, they usually do not pay off at the same time.
For example, momentum and value strategies are on opposite sides of the field.
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Why Should You Factor Invest
From a theoretical standpoint, factor investing is used to generate above-market returns, enhance diversification and manage risk. Diversifying portfolios has been a favoured method of managing risk, but you wont reap any benefits if the securities chosen are not in tandem with the overall market.
For example, an investor might consider an array of bonds and stocks that all lose value during certain market environments. Factor investing can offset potential risks by focusing on persistent, broad and well-established drivers of returns.
If you have implemented traditional portfolio allocations, like 30% bonds and 70% stocks, you might become overwhelmed by the sheer number of factors to consider.
What Is Factor Investing
Factor investing is an investment strategy that involves choosing assets based on a certain set of factors or attributes. Investors who want to follow a factor investing approach should identify characteristics that they look for in a stock. The characteristics are what they believe will be indicative of a stocks success in providing high returns.
There are two main types of factors that have historically been associated with an assets returns style and macroeconomic factors. These factors are drivers of returns that impact the returns of assets across different asset classes. Style factors are factors that explain risks and returns within each asset class, whereas macroeconomic factors are factors that explain risks across multiple asset classes.
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Complete Guide To Factor Investing
In this guide, we take you through the five key aspects of factor investing and how they’re impacted by a volatile market.
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Searching for a strategy that works in the current COVID-19 market?
Despite the grim data, the stock market is staying firm, and is just about equal to the level it was at at the start of 2020. Its no wonder then that more Americans are moving into the big bad world of day trading.
And investors are looking more to one strategy in particular, primarily due to the fact investing strategies based on factors have resulted in over $250 billion in profits over the last five years.
Disadvantages Of Factor Investing
A disadvantage of factor investing is that investors may accidentally be exposing themselves to additional risk instead of minimizing risks. For example, investors who are approaching their investing strategy using the size factor may be putting too much weight on small-cap stocks, exposing them to risks associated with investing in small, high-growth companies. Additionally, using only one factor as your investment strategy imposes many risks.
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Multifactor Exposure At Home And Across The Globe
To access multi factor exposure at home, investors can consider ETFs like WisdomTree U.S Multifactor Fund .
Here are some fund facts about USMF:
- Tracts the yield performance and price, before any expenses or fees, of the WisdomTree U.S Multifactor index.
- Typically, a minimum of 80% of the funds assets will be invested in component securities of the investments and index with economic characteristics like those of component securities.
- Generally, the index contains 200 U.S companies with the highest composite scores based on two technical and two fundamental factors and
On top of this, WisdomTree Investments offers multifactor ETFs that are actively-managed for international exposure.
The Five Key Factors Of Factor Investing
Below we will go through five factors that have been identified by academics and widely adopted by investors throughout the years as important exposures in a portfolio.
Size
Historically, when portfolios are made up of small-cap stocks they tend to show greater returns than ones made of only large-cap stocks. To capture the size you can look to the market capitalization of a stock.
Its imperative to take some time to understand how to research stocks. If you do, youll understand why its the smartest thing to do before you start investing.
Value
The aim of a value factor is to catch excess returns from stocks with low prices in relation to their fundamental value. Typically, this is tracked by price to earnings, price to book, free cash flow, and dividends.
Getting to know how dividend investing works can be tricky. It can be a safe retirement investing strategy, but you will need patience, diligence, and knowledge to succeed.
Momentum
When stocks have outperformed in the past they tend to bring strong returns in the future. To employ a momentum strategy, you look at the relative returns from about three to 12 months.
Quality
A quality factor can incorporate stable earnings, low debt, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by analysing common financial metrics such as debt to equity, earnings variability, and a return to equity.
Volatility
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Factor Investing In A Volatile Market
COVID-19 has caused the largest indices across the globe to experience rapid changes, both positive and negative, molding a practically ideal time for investors to consider factor investing.Andrew Dougan, Director of Research and Analytics at FTSE Russell was quoted in The Yorkshire Post as having said:
The approach works by scanning stocks for certain attributes called risk factors and seeks to increase an investors exposure to those that they believe will deliver the best risk-adjusted returns.
This is a stark contrast to that of traditional stock picking, where investors look at one company, analyze its financial accounts, and talk to management.
Dougan continued, Five of the most common factors, momentum, volatility, size, quality, and value, are frequently used by investment managers to construct stock portfolios, To which Dougan continued, A listed companys factor profile can, of course, change over time and many of these risk factors perform differently depending on the economic conditions.
Factor strategies are growing in popularity as investors increasingly look more to education.
Dougan noted, The approach is growing in popularity.
So what about market access to these investment strategies? One way individual investors can gain exposure to risk factors is via ETFs, where a fund passively tracks its underlying index and is traded on exchange, much like a stock.
A Brief History Of Factor Investing
Beta is Born
The first signs of this approach to investing go back to the 1960s, the same time the capital asset pricing model was first brought to light. This model hypothesizes that all stocks show at least some correlation to the volatility of the wider market and this metric was christened Beta. To learn more about stock trading, and how to invest in stocks we have created a stock trading guide for investors.
This original model theorized that one singular cause, in this case, market exposure, has everything to do with the volatility and returns of a stock. CAPM, however, outlines that outside of market exposure, other factors also affect the return of a stock. These factors are called idiosyncratic and theyre specific to individual businesses think of earnings reports, changes in management, mergers, acquisitions, or the launching of new products.
Beta Gets Smart
Following the publishing of CAPM, a lot more thinking was devoted to different factors and exposures, and how they relate to the return of a stock. In 1979, an extension of the CAPM was introduced by Stephen Ross, called the arbitrage pricing theory . This suggested that a multifactor approach could more accurately explain stock returns. It was later demonstrated that apart from the market factor, company size and its valuation are important drivers of its stock price.
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