Investments

What Is Factor Investing

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 7 minute read

The goal of any investor, regardless of their level of experience, is to maximize their wealth through the stock market. Extra profits are wanted by everyone, right? It seems like everyone has their own secret sauce for outperforming the competition. 

Throughout this essay, you may have noticed recurring themes, such as monitoring price volatility and momentum, focusing on large-cap stocks, and seeking out underpriced opportunities.

Though it may come as a surprise, the great majority of long-term investment strategies that have the potential to outperform market benchmarks are factor investing techniques.

How Does Factor Investing Work?

When it comes to maximizing returns and spreading them out across a wider portfolio, diversification and risk management are two of the most important factors in factor investing. When making judgments in the stock market, factor investors prioritize aspects of risk in order to maximize returns.

Warren Buffett, arguably the most well-known investor in the world, has made a name for himself by focusing on a widely-considered component of stock prices. The wealthy investor is always on the lookout for bargain stocks, hoping to cash in once the market rebalances and the stock’s price rises to a more reasonable level.

Generalizing, factor investing entails putting money into stocks that offer a modest return in exchange for a somewhat higher degree of uncertainty. It’s important to consider a variety of aspects, the value being only one of them.

After all, inexpensive value stocks tend to recover, but there is always the potential that a stock’s low price is due to a structural issue or business blunders that will not be easily resolved. Buffett and other value investors have consistently outperformed the market by spreading their risk across a large number of holdings over time.

Style and macroeconomic variables are two categories to keep in mind. Here are some things to keep an eye out for.

Common Style Factor Types

You can choose to use a single risk-premium factor or a combination of factors as the basis for your investment decisions. Each risk-premium element carries with it the possibility of above-average returns and a little greater degree of risk. The benefits have historically outweighed the hazards, but this hasn’t stopped these things from gaining popularity.

It is well-established that the following are the risk-premium elements that have the greatest impact on returns:

1. Value

Similar to Warren Buffett, value investors try to locate equities trading at a bargain in the hopes of profiting from their subsequent appreciation. The value component necessitates careful consideration of a company’s basic financial information, such as its free cash flow, dividends, and valuation indicators like the price-to-earnings ratio (P/E) and the price-to-sales ratio (P/S).

Buying value stocks carries a higher degree of risk because there may be a rationale behind the stock’s undervaluation that the market isn’t considering. 

For instance, if the FDA has recently rejected a biotech company’s drug, the stock price of that company could plummet, leading to low valuation measures; however, the danger of investing in a such company would likely outweigh the benefits of the undervaluation.

2. Momentum

Excitingly, the momentum factor gives extra weight to equities that have been trending in the correct direction recently. According to Newton’s first law of motion, a body in motion tends to stay in motion, and this is often the case in the stock market as well.

It’s possible that a stock’s current outperformance may persist for some time, given its strong momentum and ample liquidity. In order to capitalize on rising prices early, momentum investors scour the market for technical indicators of significant price increases.

However, riding the wave of success may be risky business. An abrupt drop could be on the horizon for momentum stocks, which are generally overvalued. You should pay great attention to technical data and be prepared to exit if you are relying on momentum considerations.

3. Volatility

Stocks with low volatility are highlighted by the volatility indicator. This is due to the fact that low-volatility stocks have historically generated higher risk-adjusted returns than high-volatility ones.

Conversely, low-volatility equities don’t typically result in spectacular short-term profits. As a result, this is something that should be considered more by long-term investors than by short-term ones.

4. Quality

There are numerous indicators that may be used to evaluate a company’s quality, but the most prominent ones are the debt-to-equity ratio, the return-on-equity ratio, and the earnings variability.

The goal is to invest in reliable businesses that have a history of success and can continue to do so under the watchful eye of competent management and with minimal debt.

Considerations of quality, such as those we’ve already discussed, are essential in any financial decision. After all, stocks of higher-quality companies are more likely to beat those of lower-quality companies since the former tend to have more steady earnings, consistent growth, excellent management, and low levels of debt.

Before deciding to use factor investing, you should think about the stock’s quality. For instance, value investors should seek out firms with above-average quality signals that are trading at lower-than-average valuations.

5. Size

Finally, a company’s size is a well-recognized determinant in determining its risk premium. Small-cap stocks have historically outperformed their large-cap counterparts, thus investors who consider company size when making investments tend to concentrate on these.

Nevertheless, there is a skill to investing in stocks with little market capitalization. There is typically more danger associated with investing in these firms because they are not as well-established as large-cap enterprises.

An illustration would be the Fama-French 3-Factor Model.

When it comes to factor investing, the Fama-French three-factor model is a popular choice. It is an extension of the Capital Asset Pricing Model (CAPM), which is used to assess the correlation between the riskiness of an investment and its potential return. To account for these complexities, Eugene Fama and Kenneth French created the three-factor Fama-French model.

The Fama-French three-factor model depends on the following three aspects of presentational style:

  1. Size. Small-cap stocks are favored by the model over large-cap ones.
  2. Value. The model uses the ratio of book value to market value to ascertain if the stock is cheap.
  3. Momentum. The model investigates the stock’s outperformance in terms of total return.

According to this investment strategy, superior returns can be obtained by purchasing shares in smaller companies that have high-value metrics and have historically outperformed the market.

Mutual Funds & Exchange-Traded Funds Factor Investing (ETFs)

Investment-grade funds such as ETFs and mutual funds provide a low-cost alternative to picking your own stock portfolio to benefit from the factor investing technique.

There are a number of exchange-traded funds (ETFs) designed around premiums for risk. Vanguard Small-Cap Value ETF (VBR) is one such ETF that has a proven track record of beating the market since it prioritizes investments based on size and value.

If you lack the time or expertise to design your own investment portfolio, you may want to investigate investment-grade funds whose management focuses on risk premiums.

Advantages of Factor Investment

There are a number of compelling arguments for exploring factor investing strategies. 

Exciting advantages of these methods include:

Increased Returns

To put it another way who wouldn’t want to increase their market profits? In the end, the goal should be to maximize profits. To facilitate this, the concept of “factoring” investing emerged. This method provides a straightforward strategy for outperforming the market by focusing on growth drivers.

No Feelings Allowed

With factor investing, you allocate capital in accordance with the risk premiums you assign to the various factors. When you follow this type of plan, you eliminate the potential for negative emotions like fear and greed to undermine your profits.

Disadvantages of Factor Investing

There is a substantial disadvantage to factor investing that should be considered before adopting the technique, despite the fact that it has several advantages.

Higher Risk

An important aspect of factor investing is deciding to take on slightly more danger in exchange for the chance to reap far larger rewards. While it’s true that the potential for profit usually surpasses the additional risk involved, it’s still wise to do thorough research and understand all the hazards that may be involved before making any investment.

Are You a Good Fit for Factor Investing?

The truth is that everyone may benefit from a well-managed investment portfolio that places an emphasis on risk premium variables. Who wouldn’t want above-average long-term returns from their investments?

However, there is a specific type of investor who should not use this strategy. The higher degree of risk involved in these techniques is likely to put off those who are close to or already in retirement and have a low tolerance for risk.

There’s little sense in taking more risks now for a bigger payout later if you’re already drawing from a nest fund.

Bottom Line

Investing in factors provides a compelling potential to replicate the success of countless other investors who have beaten commonly used benchmarks over the long term. 

Nonetheless, keep in mind that more potential returns cannot be had without also higher risk. No matter how you want to put your money to work, you should always do your homework. 

However, the necessity for investigation increases as the level of risk you’re willing to take on rises. Be sure you’re willing to put in the time and effort necessary to add a risk premium or two to your portfolio.

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