Foundational concepts for understanding factor investing
Foundational concepts for understanding factor investing
Factor investing is a third pillar of investing, complementing active and passive approaches. We explain what factors are and the role they play in portfolios.
- Factor investing is an investment strategy in which securities are chosen based on certain characteristics with the goal of achieving a given investment outcome or to improve long-term risk and return.
- Factor investing is based on rigorously studied investment factors — characteristic, quantifiable features of an asset that can be cost-effectively targeted in a diversified portfolio.
- Once understood, factor investing stands as a third pillar of investing, complementary to traditional alpha sources and market-weighted indexing with its own use cases, strengths and weaknesses.
Today, factor investing has established itself as third pillar of investing, offering investors a complementary approach to traditional active and pure passive investing.
Factor investing has a well-established and increasingly important role in investors’ portfolios.
Over 70% of institutional investors surveyed in 2018 were using factor strategies and more than 60% were planning to increase their use of them in the following years, according to the Invesco Global Factor Investing Study, which was carried out by NMG Consulting. Increasingly, however, factor-based investing has also become important for private investors and their advisers.
A growing number of investors are seeking a better understanding of the elements that drive returns and reduce risk. Factors can help investors gain this understanding and thus offer better control and transparency. Today, factor investing has established itself as a third pillar of investing, offering investors a complementary approach to traditional active and pure passive investing.
In this article, you will learn what factors are and what role they can play in a portfolio.
Factors as important indicators of risk and return
There are several reasons why factor investing has gained so much importance recently. First, exciting advancements in the study of asset pricing, largely from academia, have shown the huge potential for factor-based strategies to play a major role in diversified portfolios. Second, factor analysis frequently helps explain portfolio behavior in ways that were previously not well understood; even for portfolios that do not utilize a factor approach. Factors help explain risk and return, allowing greater granularity, control and customization. This transition is supported by decades of empirical research and is likely a permanent advancement in how assets are managed.
As explained earlier, factor investing consists in selecting securities based on certain attributes. But what attributes are we referring to? Factor investors focus on features of securities containing material information about their risk and return. There are two major categories: macro factors and style factors.
The macro factors are well-known and intuitive. They relate to the influence that factors such as economic growth and inflation rates have on security prices. Consider inflation for example. Inflation broadly impacts financial and economic environments. Changes in expected inflation impact prices across stocks, bonds, commodities; just about any asset class. Many markets have options to invest directly in inflation factor strategies such as TIPS or linkers.
Recent focus in research and development has increasingly shifted toward style factors. Therefore, when someone talks about factor investing today, they are often referring to style factors, rather than macroeconomic factors. For this reason, the bulk of the following discussion is focused on style factors.
Value, size and volatility
With value strategies, the emphasis is placed on securities that are priced at a discount to other similar securities. The underlying assumption is that, over the long term, purchasing securities at lower prices will lead to higher returns. But how do you determine value? As it turns out, there are many different approaches that yield similar results. The index provider MSCI, for example, uses dividend yield, price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio) as criteria. Cash flows and net profit are sometimes used as criteria as well. Price-to-book — as well as size — was used in 1992 by the scholars Eugene Fama and Kenneth French to expand the capital asset pricing model to produce the Fama-French three-factor model1. In the fixed income context, value strategies can measure yield relative to credit rating by industry. However, there are also points of criticism. Quite apart from the fact that value strategies aren’t successful in all market phases, there is the considerable concern that innovative companies that don’t pay dividends and have a high price-to-book value are excluded. For this reason, Invesco often prefers cash flow yield as a measure of value in equities.
With size (i. e. small cap) strategies, the focus is on the shares of small companies in the expectation that they will outperform those of large companies. This relationship was first demonstrated in a study by Rolf W. Banz in 19812. Subsequent studies confirmed these results. There are several explanations for the size factor. On the one hand, it is claimed that small companies have better growth prospects than large established companies. On the other hand, analysts focus less on these companies, which therefore tend to be overlooked. It is also said that the shares of small companies are not as liquid as those of their larger counterparts, with investors preferring the shares of large companies. In some markets, the consistency and magnitude of the size factor is tenuous, but it is often observed that other investment factors seem to work quite well across smaller companies, which increases its usefulness.
The volatility factor (also known as minimum volatility or minimum variance) implies that shares associated with lower volatility perform better on a risk-adjusted basis than those with higher volatility. The observation was first described in 1972 by Robert Haugen and A. James Heins3. Later studies also found that low-volatility shares outperformed those with high volatility over the long term on a risk-adjusted basis. What might be the rationale to explain this unexpected phenomenon? One possibility is a difference between reality and the realm of academic research. Given a set of assumptions, theory says investors should be indifferent between low and high volatility stocks because of access to leverage. In reality, investors may not be able to access leverage, or the costs of leverage might be higher than assumed in the research. This practical reality could cause investors to be willing to accept less incremental return as volatility increases. On the other hand, the approach is criticized for its poor sector coverage, with low volatility healthcare stocks overrepresented, for example. One note about the low-volatility factor: The most rigorous studies of this phenomenon find results are largely driven by poor returns of highly volatile securities. This result has important implications when considering a low-volatility investment, but details of this finding are beyond the scope of this introduction.
Momentum and quality
Within the framework of momentum strategies, the most known factor is price momentum. Securities are purchased if they have performed well recently, and sold if they have performed badly. The outperformers of the recent past are therefore seen as the outperformers of the future4. This factor was “discovered” by Jegadeesh and Titman in 19935. Momentum strategies are usually justified by the findings of behavioral finance, which focuses on known modes of behavior, such as the herd mentality, or anchoring bias for example. More recent studies find that earnings momentum largely subsumes price momentum. Earnings momentum is commonly defined as the trend in earnings surprises or changes in earnings expectations. The rationale for earnings momentum is similar to price momentum, although the finding impacts how the factor is captured in portfolios. Recent research suggests that the momentum factor also persists for bonds, measured by return over a recent period of time.
The quality factor entails a focus on the shares of high-quality companies because they tend to outperform those of lesser quality. Robert Noxy-Marx demonstrated in 20126 that the shares of highly profitable companies achieve better risk-adjusted performance than less profitable companies. Other criteria that are used to define quality include cash flows and debt ratios, as well as the quality of the management and business model, along with the market environment, and, with fixed income, a high credit rating, low duration, and low historical volatility. However, it is problematic that some elements of quality often can’t be measured, such as the value of a brand or good reputation. Not least, there is the danger that young high-growth companies — which don’t yet have steady earnings — are excluded, as are companies that are highly sensitive to economic trends.
Factor investments: At times perform better than the market
Professional investors’ special interest in investment factors becomes understandable if the returns on factor-based equity portfolios are considered and compared with general market developments. Indeed, factor investing has at times outperformed the market in the long term.
Factor investing versus stock picking
Professional investors’ special interest in investment factors becomes understandable if the returns on factor-based equity portfoliWhat is the difference between factor investing and traditional stock picking, as it has long been practiced? After all, many traditional fund products have “value” or “size” in their name.
The essential difference is in the security selection process. Stock picking involves leveraging a unique skill or information source to determine which securities are undervalued, and evaluates characteristics of securities based on criteria defined by the investment manager. Factor investing involves a rules-based approach, picking securities that exhibit particular characteristics based on solid and objective rationale drawn from quantitative data and applied using a systematic process. Commonly, stock picking involves deliberately concentrating on the most undervalued securities, while a factor approach maintains broad diversification across securities to reduce security specific risk.s are considered and compared with general market developments. Indeed, factor investing has at times outperformed the market in the long term.
How the effectiveness of factors can be explained
Empirically speaking, the data of global style factor indices show that factors have generated a better return than the market over the long term. However, investors who make their investment decisions for the future also want to understand the reasons for this phenomenon. This is why the rationale is so important.
Factors: Not always superior
Factors: Not always superiorWhile it can be demonstrated relatively easily that factor investments produce above-average returns over the very long term, large fluctuations and differences in returns are possible in the short and medium term. Different factors display strengths and weaknesses in different economic and market environments, with one factor outperforming in one environment and the other doing better in another environment. Successful predictions (timing) are exceedingly difficult.
The different return patterns of factors during different market phases also offer opportunities. As mentioned before, enhanced diversification is one potential benefit of factor investing. Over the long term, investment factors have captured a premium over market cap-weighted indices. Since factors often perform differently at different points in the economic cycle, factor investing can enhance diversification. Multi factor strategies seek to exploit this benefit within the portfolio while single factor strategies can complement the broader client portfolio.
Factor strategies: active or passive?
Factor strategies that are implemented with rules-based ETFs have recently attracted a lot of attention and have managed to pool significant amounts of investor capital. This can create the impression that factor strategies are always best suited to passive investment products. But a closer look reveals that factor strategies — even as rules-based ETFs — can entail a high level of activity in terms of the steady turnover of securities. For example, the momentum strategy naturally involves changing large portions of the investment portfolio, such as when a steady trend shifts after being effective for a long period of time.
In any case, factor investments aren’t only reserved for passive investment products and ETFs. Quite the opposite, in fact: Active management teams have been using factors for decades to assemble and structure their portfolios — even though these often don’t carry the “factor investing” label. A look at the history of factor research also shows that factors in active management are much older than ETFs.
The core differences between active and index-based factor investing
Active quantitative managers typically use self-developed factors or multi-factor models that are constantly monitored and enhanced. The active manager’s work is at the core of the optimization process. As a result, these strategies often lack transparency for investors — except when it comes to the main features and objectives. Index-based products on the other hand are fully transparent, and their rules governing how securities are selected are set once the index has been launched.
Factor investing in the fixed income area
In the bond area, factor investing is in the earlier stage of adoption, as compared to equities. In recent years, however, many papers have been written by both academics and practitioners. Further, since the rationale at the core of investment factors are not asset class specific, satisfied equity factor investors are increasingly moving on to factor applications with bonds.
When it comes to government and corporate bond indices, the usual weighting of securities based on market capitalization causes special problems — because it means that high weightings are assigned to the most highly indebted countries and companies, respectively. Investors will therefore disproportionately be invested in issuers with the highest debt burden. This will generally be undesirable. Instead, issuers that can pay back their debts should be more in demand.
Furthermore, the indices are often even less balanced than equity indices. For example, many global government bond indices have a strong US and Japan bias, while many corporate bond indices primarily contain bonds from the financial sector.
Today, there are also some promising approaches to apply well-known style factors to fixed income strategies. In very general terms, value can be interpreted as meaning that a financial asset is cheap relative to other bonds by some measure. The application of the quality factor to the bond sector is viewed as particularly promising, as is the size factor by focusing on smaller issuers.
Factors in an investor’s portfolio — for good reasons
Now that we have gained a general understanding of factors, the key question is how factor investing is used in investor portfolios and what its objectives are. In general, a strategic portfolio that is diversified according to factors may reduce the risk and enhance the return potential in the long term compared with the broad market. Depending on their individual starting point and investment portfolio, investors may use factor strategies for different reasons.
Some of the key considerations are:
- In a portfolio with traditional market-weighted strategies, index-based factor strategies (frequently referred to as “smart beta” strategies) can offer a cost-efficient means of increasing return potential of the portfolio or used as a tool to balance overall factor exposures.
- Investors with a portfolio consisting of market-weighted strategies may use active quantitative factor strategies to apply customized objectives like ESG to pursue excess return or achieve a more effective risk diversification.
- Investors who have traditionally invested in fundamental active strategies may decide to add factor strategies to increase diversification, smooth allocations, directly target factor premiums or lower total investment costs.
- Investors who already use index-based factor strategies might switch to active factor strategies to achieve more efficient implementation, allow for advancements in techniques or increase effective risk diversification.
In the process, the decision to use factor strategies in a portfolio does not have to be strategically motivated. As the following chart shows, factor strategies can also be used tactically.
Multi-factor investing: Relevant solutions for different investor needs
The case for multi-factor:
- Single-factor portfolios are not neutral to other factors due to cross-effects between factors
- A holistic approach in constructing multi-factor portfolios results in higher desired factor exposures compared to a naive (equal weighted) allocation of multiple single factors
- Multi-factor construction can lead to improved efficiency of the overall portfolio
Blaise Warren is Chief Operating Officer for Global Factor Investing at Invesco. Stephen Quance is Global Director of Factor Investing at Invesco.
Factor investing at Invesco
^1 Fama, E, and French, K: ‘The Cross-Section of Expected Stock Returns’, Journal of Finance, 1992; Fama, E, and French, K, ‘Common risk factors in the returns on stocks and bonds’, Journal of Financial Economics, 1993.
^2 Rolf W. Banz, Journal of Financial Economics, 1981.
^3 Robert A. Haugen, A. James Heins, Wisconsin working Paper, 1972.
^4 Actual events are difficult to predict and may substantially differ from those assumed. There can be no guarantee that the assumptions discussed will come to pass.
^5 Narasimhan Jegadeesh and Sheridan Titman, Journal of Finance, 1993.
^6 Robert Novy-Marx, Quality Investing; Working Paper, December 2012, revised May 2014.
^7 Since ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the cost of ETFs.
^8 ETFs disclose their full portfolio holdings daily.
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