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May 29, 2024

Wednesday Investment Wisdom: What is Factor Investing?

by Detlef Glow.

Whenever there are opportunities to generate enhanced returns, the global asset management industry will seek to exploit these opportunities. This is especially true when there are market anomalies which have a well-researched potential to generate additional returns, the so-called alpha, over the long run in the portfolios of investors. Some of these well-researched sources of alpha are the so-called factors.

Factor investing is an investment approach that targets specific quantifiable characteristics of a security, which can explain differences in the returns of securities. There are three kind of factors which can be seen as drivers for the returns of all kinds of securities from all asset types, macroeconomic factors, microeconomic factors, and style factors.

Macroeconomic factors are less used to create factor-based investment products include the inflation rate, GDP growth, unemployment rate, etc.

Microeconomic factors include, for example, the credit rating of a company, bond and equity liquidity, volatility of the stock price, stock price momentum, etc., while style factors include value versus growth, market capitalization, quality of the balance sheet, industry sector assignment, etc.

As the respective characteristics of the different factors are quantifiable, it is not surprising that factor-based investment approaches are normally purely quantitative.

That said, quantitative factor-based investment approaches normally derive their portfolio constituents from a broad market index by implementing screens for those securities which fulfill the respective criteria best. The weighting of the individual components within the portfolio can be based on an evaluation of how strongly the security matches the factor criteria, the market capitalization of the individual securities or through an equal weighting of the securities.

Which factors work?

Of the many factors described in the scientific literature that can be used for factor-based investments, only five factors appear to work best in the long term.

These factors are:

Value factor – The value factor is known by most investors. Investment products based on the value factor, try to take profit from a mispricing between the fundamental value of a security and its market value. A systematic quantitative value factor-based investment approach purchases undervalued securities and holds the positions until the market adjusts its valuation of the respective security. Since, the dividend yield and the quality of the balance sheet are also important measures for discretionary value managers, these factors can be seen as sub-factors of the value factor.

Momentum factor – Investment products based on the momentum factor are buying securities which have outperformed their peers in a given market (index) over a predefined time period, while selling the underperforming securities of the respective market (index).

Liquidity factor – Investment products based on the liquidity factor try to harvest a premium for the lower trading liquidity of a security.

Low-volatility factor – Investment products based on the low-volatility factor buy securities with a low-volatility in a given market (index), while avoiding those with high volatility. These strategies include, beside others, equal risk contribution (ERC) and maximum Sharpe ratio strategies. Low-volatility strategies tend to reduce losses in bear markets, while lagging performance during bull markets, which means the results of low-volatility strategies need a full market cycle before they can be evaluated.

Size factor – Investment products based on the size factor try to profit from the fact that stocks can grow from small caps to mid caps to blue chips when their market value increases over time. With regard to this, investment products utilizing the size factor are mainly invested in small and mid caps.

 

Even if it has been theoretically and practically proven that the implementation of a factor-based investment approach can lead to an outperformance of the respective portfolio compared to its parent market (index) in the long term, it needs to be considered that factors do not work in every market environment. This means that there are periods in which factor-based investment products underperform their market (index).

In addition, some scientific studies indicate that the manifestation of some of the factors mentioned above, such as the size factor or the liquidity factor, appears to be decreasing, which reduces the return potential of these strategies.

With regard to the above, the question of the right timing for buying and selling a respective factor plays an important role for the investment success of the investor with this kind of products. In order to compensate for this disadvantage, some asset managers have been developed multi-factor models that should be able to achieve the most consistent excess returns possible through an optimized combination of individual factors.

 

This article is for information purposes only and does not constitute any investment advice.

The views expressed are the views of the author, not necessarily those of Lipper or LSEG.

 

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