Factor investing is astrategythatchooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.
Some common macroeconomic factors include: the rate of inflation; GDP growth; and the unemployment rate. Microeconomic factors include: a company's credit; its share liquidity; and stock price volatility. Style factors encompass growth versus value stocks; market capitalization; and industry sector.
Key Takeaways
- Factor investing utilizes multiple factors, including macroeconomic as well as fundamental and statistical, to analyze and explain asset prices and build an investment strategy.
- Factors that have been identified by investors include: growth vs. value; market capitalization; credit rating; and stock price volatility - among several others.
- Smart beta is a common application of a factor investing strategy.
Understanding Factor Investing
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.Portfolio diversification has long been a popular safety tactic, but the gains of diversification are lost if the chosen securitiesmove in lockstep with the broader market. For example, an investor may choose a mixture of stocks and bonds that all decline in value when certain market conditions arise. The good news is factor investing can offset potential risks bytargeting broad, persistent, and long recognized drivers of returns.
Since traditional portfolio allocations, like60% stocks and 40% bonds, are relatively easy to implement,factor investing can seem overwhelming given the number of factors to choose from.Rather than look at complex attributes, such as momentum, beginners to factor investing can focus on simpler elements, such as style (growth vs. value), size (large cap vs. small cap), and risk (beta). These attributes are readily available for most securities and are listed on popular stock research websites.
Foundations of Factor Investing
Value
Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.
Size
Historically, portfolios consisting of small-cap stocks exhibitgreater returns than portfolios with just large-cap stocks. Investorscan capture size by looking at the market capitalization of a stock.
Momentum
Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three monthsto a one-year time frame.
Quality
Qualityis defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks by using common financial metrics like a return to equity, debt to equity and earnings variability.
Volatility
Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one-to three-year time frame is a common method ofcapturing beta.
Example: The Fama-French 3-Factor Model
One widely used multi-factor model is the Fama and French three-factor model that expands on the capital asset pricing model (CAPM). Built by economists Eugene Fama and Kenneth French, the Fama and French model utilizes three factors: size of firms, book-to-market values, and excess return on the market. In the model's terminology, the three factors used are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB accounts for publiclytraded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.
FAQs
Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors.
What are factor strategies in investing? ›
Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. There are two main types of factors: macroeconomic and style. Investing in factors can help improve portfolio outcomes, reduce volatility and enhance diversification. 00:00.
What factors should be considered when creating your investing strategy? ›
Here are the top ten essential factors to consider while making investment decisions.
- Risk tolerance. Your risk tolerance is your ability to withstand financial losses. ...
- Investment time horizon. ...
- Investment objective. ...
- Asset allocation. ...
- Fundamentals of the investment. ...
- Market trends. ...
- Fees and charges. ...
- Tax implications.
What Is an Investment Strategy? The term investment strategy refers to a set of principles designed to help an individual investor achieve their financial and investment goals. This plan is what guides an investor's decisions based on goals, risk tolerance, and future needs for capital.
What factor is most important for you while choosing an investment? ›
Risk Tolerance
One of the major factors to consider before investing is to measure your risk tolerance, meaning that you should evaluate whether you wish to play safe or take some risks and whether you have a high-risk tolerance or moderate risk appetite.
What are the 5 factors in factor investing? ›
BLACKROCK'S APPROACH TO FACTOR INVESTING. BlackRock has identified five factors — value, quality, momentum, size, and minimum volatility — that have shown to be resilient across time, markets, asset classes, and have a strong economic rationale.
What is a factor strategy? ›
Factor investing is a strategy that chooses securities on attributes that are associated with higher returns.
What are the 4 factors to consider when investing? ›
Here they are, in no particular order:
- Return on Investment (ROI) ROI is often considered to be the holy grail of all metrics when it comes to assembling one's portfolio. ...
- Cost. ...
- Time to Goals. ...
- Tax Considerations. ...
- Liquidity.
Buy and hold
A buy-and-hold strategy is a classic that's proven itself over and over. With this strategy you do exactly what the name suggests: you buy an investment and then hold it indefinitely. Ideally, you'll never sell the investment, but you should look to own it for at least 3 to 5 years.
What are three key factors to remember in establishing your investment strategy? ›
How to Choose Your Investment Strategy
- Set Financial Goals. Your financial goals will help shape your investment strategy. ...
- Determine Your Risk Tolerance. Investing involves some degree of risk, and your appetite for it will likely guide your investment choices. ...
- Understand the Importance of Diversification.
Strategy is where you will focus your efforts to achieve your goals, and how you will succeed—or, “where to play and how to win.” It defines a specific course of action that will take you from where you are now to where you want to be.
What is an example of a strategic investment? ›
Strategic investment deals are structured as a common or preferred share financing from a company (for example, Cisco, Intel, Google) investing in startup companies developing technologies complementary to their businesses.
How does a strategy work? ›
[S]trategy is an iterative process in which all of the moving parts influence one another and must be taken into account together. The heart of strategy, according to Lafley and Martin, is deciding where to play and determining how you will win there. What business are you in?
Why is an investment strategy important? ›
Investment strategies can help you make quick decisions about whether or not to purchase an asset for your portfolio, reducing decision fatigue and the fear that you've made the wrong choice.
What are the three important factors to evaluate investments? ›
Returns on assets (ROA), returns of equity (ROE), and net margins are other key indicators and any Clifton NJ CPA will help you interpret these. In addition to assessing the company's financial records, you should also conduct a situational analysis of the firm to determine its market standing.
What are the 2 major types of investing strategies? ›
There's much debate about the relative merits of active and passive — two common investing styles — which are based on very different views of how capital markets operate. You can find out more about active and passive investing in Beyond the benchmark: active or passive investment management?
What is factor risk in investing? ›
What is a risk factor? Risk factors are the underlying risk exposures that drive the return of an asset class (see Figure 2). For example, a stock's return can be broken down into equity market risk – movement within the broad equity market – and company-specific risk.
What are the advantages of factor based investing? ›
Advantages of Factor Investing
Factor investing provides the benefits of diversification, which minimizes a portfolio's exposure to risk. Factors can improve diversification because style and macroeconomic factors cover various situations in the economic cycle.
