Factor investing is an investment strategy that involves choosing assets based on a certain set of factors or attributes. Investors who want to follow a factor investing approach should identify characteristics that they look for in a stock. The characteristics are what they believe will be indicative of a stock’s success in providing high returns.
There are two main types of factors that have historically been associated with an asset’s returns – style and macroeconomic factors. These factors are drivers of returns that impact the returns of assets across different asset classes. Style factors are factors that explain risks and returns within each asset class, whereas macroeconomic factors are factors that explain risks across multiple asset classes.
History of Factor Investing
Factor investing originated from the Capital Asset Pricing Model (CAPM), a theory that strived to explain an asset’s returns relative to its sensitivity to market risk. Although the CAPM helped provide a framework for pricing assets, empirical research provided evidence that stock market returns did not exactly follow the model’s framework. Instead, there was evidence that stock market returns were correlated to the stock’s characteristics.
One of the earliest observations was that the size of a company’s market capitalization is an important consideration for investors. Small-cap stocks usually perform better than large-cap stocks, which explains the performance of stock returns that deviates away from the explanations provided by the CAPM.
Value investing involves buying assets that are underpriced using fundamental analysis. It is most often measured using the price-to-earnings ratio, the amount of dividends, and the quantity of free cash flows of the company.
As mentioned above, the size of the company is also an important consideration for investors as well. In factor investing, investors are more inclined to include small companies with high growth because small-cap stocks historically provide higher earnings than large-cap stocks.
Investors want to invest in a company that is financially healthy. It means having low debt-to-value ratios, high return on assets, and high return on equity.
Investors also consider the momentum of stocks, which refers to how stocks with strong, positive returns will likely continue to exhibit upward price trends in the future, attracting the attention to invest in such stocks. In particular, a momentum investing strategy looks at a stock’s short-term returns from three months to one year.
Empirical evidence suggests that stocks with lower fluctuations in their stock prices tend to outperform stocks with more fluctuations.
1. Economic growth
If the economy is growing, companies are more likely to increase their profits with a rise in consumer spending, which also improves the stock market’s performance. On the other hand, a downturn in the economy puts companies in a more difficult position to earn profits, leading to a decline in stock prices.
Inflation impacts stock prices because it affects how much consumers spend. When the cost of goods or services increases, consumers are less likely to spend more money. It negatively impacts businesses because consumers are not willing to make as many purchases with reduced purchasing power.
Factor investing based on a company’s credit involves investing in stocks that provide compensation for the investor for holding onto a stock with default risk. Different types of bonds come with varying degrees of default risk, so investors should choose specific bonds with exposure to the amount of market risk they prefer.
4. Interest rate changes
An increase in interest rates prevents businesses and individuals from borrowing money or taking out loans from the bank. It slows down consumer spending and economic activity.
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.
Factor investing is also associated with the benefits of high returns because the strategy follows a stock’s traits that have historically generated positive earnings. For example, empirical evidence suggests that following a quality-based factor investing approach generates positive returns, as investors put their money in financially healthy companies.
Therefore, investing in assets that use the factor investing approach can help enhance returns, reduce risk, and improve diversification.
Disadvantages of Factor Investing
A disadvantage of factor investing is that investors may accidentally be exposing themselves to additional risk instead of minimizing risks. For example, investors who are approaching their investing strategy using the size factor may be putting too much weight on small-cap stocks, exposing them to risks associated with investing in small, high-growth companies. Additionally, using only one factor as your investment strategy imposes many risks.
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