Factor Investing: Understanding the Strategy

What Is Factor Investing?

Factor investing chooses securities based on attributes associated with higher returns. There are two main types of factors: macroeconomic factors and style factors. Macroeconomic factors capture broad risks across asset classes, while style factors explain returns and risks within asset classes.

Macroeconomic factors include: inflation rate, GDP growth, and unemployment rate. Microeconomic factors include: company credit, share liquidity, and stock price volatility. Style factors encompass growth versus value stocks, market capitalization, and industry sector.

Key Takeaways

• Factor investing uses multiple factors to analyze and explain asset prices and build an investment strategy.
• Investors identify factors such as growth vs. value, market capitalization, credit rating, and stock price volatility.
• Smart beta is a common application of factor investing.

Understanding Factor Investing

Factor investing aims to enhance diversification, generate above-market returns, and manage risk. It offsets potential risks by targeting broad, persistent drivers of returns.

Instead of complex attributes, beginners can focus on simpler elements like style, size, and risk. These attributes are readily available on stock research websites.

Foundations of Factor Investing

Value

Value captures excess returns from stocks with low prices relative to fundamental value. It is tracked by price to book, price to earnings, dividends, and free cash flow.

Size

Small-cap stocks historically exhibit greater returns than large-cap stocks. Investors can capture size by considering market capitalization.

Momentum

Stocks that have outperformed tend to continue strong returns. Momentum is based on relative returns from three months to one year.

Quality

Quality is defined by low debt, stable earnings, and consistent asset growth. Common financial metrics like return on equity, debt to equity, and earnings variability identify quality stocks.

Volatility

Stocks with low volatility earn greater risk-adjusted returns. Measuring standard deviation over one to three years captures beta.

Example: The Fama-French 3-Factor Model

The Fama-French three-factor model expands on the capital asset pricing model (CAPM). It utilizes three factors: size of firms, book-to-market values, and excess return on the market. SMB (small minus big) accounts for companies with small market caps that generate higher returns, while HML (high minus low) accounts for value stocks with high book-to-market ratios that generate higher returns compared to the market.