Let’s take a look at how factor investing works in practice and how it can be applied to your portfolio.
Definition and Examples of Factor Investing
Factor investing, also known as smart beta investing, is a form of investing based on factors that are proven to drive stock returns. Research has shown that stock returns are driven mostly by market performance and individual company characteristics but that these five attributes also have contributed notably to returns. Thus, if you screen stocks and only invest in the ones that pass the factor tests, you may beat the market. The factors are:
Value (undervalued beats overvalued)Size (small beats big)Volatility (low volatility beats high)Momentum (stocks already going up will keep doing so)Quality (high returns on capital are better than low)
Other factors that aren’t so consistent or don’t have as much of a factor in driving returns are also sometimes included, dividend yield and trading volume being the most common among those. Factor investing originated with the Capital Asset Pricing Model (CAPM), which was developed in the early 1960s. The CAPM implied that the main factor for all stocks was the market. The Fama-French model was next, showing that size and value also drive returns. Over time, researchers discovered the other factors listed above and showed how they can generate excess returns. For example, researchers for investment management firm AQR Capital Management found that even Warren Buffett’s prior performance in stock picking can be explained by factors. The researchers showed that you could’ve duplicated Buffett’s returns by focusing on the value, quality, and low-volatility factors and applying leverage. Buffett’s average leverage ratio was 1.70x. The macroeconomics factors aren’t as popular among investors, but they’re still important for use when diversifying your portfolio across asset classes. The factors are:
Gross domestic product, or GDP (economic growth is good)Interest rates (depends on the asset class)Inflation (depends on the asset class)Credit (lower credit risk is better)Emerging markets (generally return more than established markets)Liquidity (the less liquid the assets held, the better)
How Does Factor Investing Work?
There are tons of mutual funds and exchange-traded funds (ETFs) focusing on each of the factors. If you want to invest in low volatility, you can simply search for a “min-vol,” or minimum volatility ETF. Because the ETFs are managed passively (in other words, stocks are selected based on a screen or index, not by an active manager) they almost all have very low expense ratios. Let’s go over how each of the factors is used and why it works.
Value
The value factor was originally based on the price/book ratio of stocks. This has evolved over time and now most factor funds use a combination of several ratios, including price/book and price/earnings. Some funds even develop proprietary measures of value to use as a competitive advantage. The value factor works because everything in the market eventually regresses to the mean. Undervalued stocks that are ignored for a short period eventually will reach properly valued or overvalued status.
Size
Smaller-company stocks return more than big stocks. Funds that use this factor focus on small-cap stocks. Small-caps are stocks with a market cap between $300 million and $2 billion. Small-cap companies are less established than large caps and thus are generally riskier. This additional risk, plus more room for growth, is usually what drives superior returns.
Volatility
Volatility is measured using beta, which is a comparison of a stock’s volatility to the market’s. For example, if a stock has a beta of 1.50 and the market goes up 10%, the stock is expected to go up 15%. The same effect is true on the downside. Volatility is used as a rule of thumb for riskiness. Over time, lower-volatility stocks outperform because they are less risky. Many investors will use the low-volatility factor to diversify. Low volatility tends to outperform in down markets, so if you invest driven by the small factor (which is higher-risk) you can still outperform with the low-vol factor during bear markets.
Momentum
Momentum is calculated by ranking the returns over the recent past (usually up to one year) and choosing the top quintile or quartile of stocks with the highest returns. Momentum, or trend-following, works because investors want to pile in on stocks already going up.
Quality
Everyone has their own quality measurement. For some, it is return on capital. For some people, it is profitability. For others, it is the actual quality of earnings when comparing with cash flow. Each of these measures does well over time. If you invest in a quality-factor ETF, the prospectus will spell out how the ETF determines quality. Quality outperforms because it tends to persist over time. If you’ve managed to keep high profitability on the way to becoming a billion-dollar-plus-revenue company, it’s likely you have some sort of competitive advantage.
What It Means for Individual Investors
It’s important to keep in mind, though, that the factors are expected to outperform the broad market primarily over the long term. Each of these factors has longer periods in its history where it underperforms the general market or even has significant drawdowns. One way managers try to get around this is by diversifying among the factors and by using the macroeconomic factors to construct their portfolios. This approach is called smart beta investing.
