Complete Guide to Factor Investing

Searching for a strategy that works in the current (ever-lasting) COVID-19 market?

Despite the grim data, the stock market is staying firm, and is just about equal to the level it was at at the start of 2020. It’s no wonder then that more Americans are moving into the big bad world of day trading.

And investors are looking more to one strategy in particular, primarily due to the fact investing strategies based on factors have resulted in over $250 billion in profits over the last five years. 

However, factor investing has been employed by investors for decades – with investors seeking to achieve the higher levels of return that exposure to certain factors can bring about – without necessarily taking on any additional risk. So, what are the key factors to consider? And how will they perform in the current market? We’ll focus our attention on three main topics:

• Examining the five key factors to consider.
• Showing how they perform with regard to economic cycles.
• Discussing how factor investing is expected to perform in the current market.

What is Factor Investing?

Factor investing is an approach taken to investing where investors target specific drivers of return across asset classes. Investing in factors can help improve the overall performance of portfolios including enhancing diversification and reducing volatility.

A Brief History of Factor Investing

Beta is Born

The first signs of this approach to investing go back to the 1960s, the same time the capital asset pricing model (CAPM) was first brought to light. This model hypothesizes that all stocks show at least some correlation to the volatility of the wider market – and this metric was christened Beta. To learn more about stock trading, and how to invest in stocks we have created a stock trading guide for investors.

This original model theorized that one singular cause, in this case, market exposure, has everything to do with the volatility and returns of a stock. CAPM, however, outlines that outside of market exposure, other factors also affect the return of a stock. These factors are called idiosyncratic – and they’re specific to individual businesses – think of earnings reports, changes in management, mergers, acquisitions, or the launching of new products.

🤓 Beta Gets “Smart” 

Following the publishing of CAPM, a lot more thinking was devoted to different factors and exposures, and how they relate to the return of a stock. In 1979, an extension of the CAPM was introduced by Stephen Ross, called the arbitrage pricing theory (APT). This suggested that a multifactor approach could more accurately explain stock returns. It was later demonstrated that apart from the market factor, company size and its valuation are important drivers of its stock price.

Later research by Eugene Fama and Kenneth French demonstrated that besides the market factor, the size of a company and its valuation are also important drivers of its stock price.

In this case, it’s important to have a good understanding of the average stock market return, and why the annual average stock return has steadied at 10%, in the last 100 years.

Factors can also be thought of as anomalies, because they deviate from what is standard. In this case it is the “efficient market hypothesis,” which implies that the market cannot be consistently outperformed because stock prices take in and reflect the information available. And while there are factors that can generate excess returns over time, others highlight the risks of stocks without necessarily offering a return premium. 

For example, you could argue that CAPM beta, does not bring excess returns over time; it only measures the sensitivity of a stock to movement in the market and might alternatively be a risk factor. 

As a result, you can’t outperform the market through exposure to market beta by itself. To gain returns in excess of the market might look to other factors which have shown to outperform the market over the long term: These are known as “smart” betas.

These factors have been employed by investment managers over the years to create and improve their portfolios. Once you can identify the relevant factors that drive return, you can measure the exposure consistently to make sure your portfolio is set up to utilize these factors.

There are various ways to understand stock trends, determining the value of a stock, and knowing when to buy or sell. Fundamental stock analysis could be a useful way to take all of these factors into account. Stay aware of current trades, right now CEOs are selling their company’s stock, which could be a bad sign for the epic market rally.

Why Should You Factor Invest?

From a theoretical standpoint, factor investing is used to generate above-market returns, enhance diversification and manage risk. Diversifying portfolios has been a  favoured method of managing risk, but you won’t reap any benefits if the securities chosen are not in tandem with the overall market.

For example, an investor might consider an array of bonds and stocks that all lose value during certain market environments. Factor investing can offset potential risks by focusing on persistent, broad and well-established drivers of returns.

If you have implemented traditional portfolio allocations, like 30% bonds and 70% stocks, you might become overwhelmed by the sheer number of factors to consider. 

⭐️ The Five Key ‘Factors’ of Factor Investing

Below we will go through five factors that have been identified by academics and widely adopted by investors throughout the years as important exposures in a portfolio.

📊 Size

Historically, when portfolios are made up of small-cap stocks they tend to show greater returns than ones made of only large-cap stocks. To capture the size you can look to the market capitalization of a stock.

It’s imperative to take some time to understand how to research stocks. If you do, you’ll understand why it’s the smartest thing to do before you start investing.

💰 Value

The aim of a value factor is to catch excess returns from stocks with low prices in relation to their fundamental value. Typically, this is tracked by price to earnings, price to book, free cash flow, and dividends.

Getting to know how dividend investing works can be tricky. It can be a safe retirement investing strategy, but you will need patience, diligence, and knowledge to succeed.

🚅 Momentum

When stocks have outperformed in the past they tend to bring strong returns in the future. To employ a momentum strategy, you look at the relative returns from about three to 12 months.

🎯 Quality

A quality factor can incorporate stable earnings, low debt, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by analysing common financial metrics such as debt to equity, earnings variability, and a return to equity.

📉 Volatility

Empirical research shows that when stocks have low volatility they earn higher risk adjusted returns than more volatile assets. A common method of capturing beta is measuring a typical deviation from a one to three year time frame. If you are looking for a low risk option, you should consider the benefits of tax lien investing. This minimizes risk and increases profit, which could be the ideal option for low risk investors.

The Fama-French 3-Factor Model

The Fama and French 3-factor model is a widely used model created by Eugene Fama and Kenneth French that adds to CAPM. This model incorporates three factors: book-to-market values, size of firms, and excess return on the market. The model uses HML (high minus low) SMB (small minus big) and the portfolio’s return less the risk free rate of return.

The HML accounts for stocks with higher book-to-market ratios that generate higher returns in comparison to the market. SMA accounts for stocks with smaller market caps, generating higher returns.

♼ The Cyclicality of Factor Performance 

The evidence has proven that using these key factor exposures can result in significant results to your portfolio. That said, there isn’t one factor that works every time, and the returns can be cyclical.

For example, small-caps can underperform large-caps for multi-year periods, in the same way they did during the late 1990s technology “bubble”, and the 2008-08 financial crisis.

When value stocks plummeted in the midst of the high-growth tech bubble they succeeded in earning back their losses afterwards. When the market changes in direction quickly it is usually at the detriment to momentum strategies – like the collapse of the tech bubble in 2000, and after the bounce back from the financial crisis

Generally, quality portfolios perform lower during low-quality rallies – such as in 2003 when the beaten down stocks drove the market to rebound. Lastly, bear markets, like the one in 2009, generally lead to low-volatility stocks underperforming.

Investors might find these performance swings unnerving, resulting in them selling and missing on the gains on the rebound. Overall, factors are not really correlated with each other – they are affected by distinct market anomalies and, as a result, they usually do not pay off at the same time.

For example, momentum and value strategies are on opposite sides of the field.

Momentum investors purchase stocks that are on the rise and are likely to stay going up, while value investors purchase stocks that are declining in value and therefore cheap to buy. The particular cyclicality of factor returns might make it tempting to try and time exposures.

Of course, factor strategies can help tactically minded investors accelerate their performance by getting exposure at the best time. But, in the same way as timing the market, factor timing and diversifying across a myriad of strategies might be an effective choice for long-term investors.

Factor Investing in a Volatile Market

COVID-19 has caused the largest indices across the globe to experience rapid changes, both positive and negative, molding a practically ideal time for investors to consider factor investing.Andrew Dougan, Director of Research and Analytics at FTSE Russell was quoted in The Yorkshire Post as having said:

“The approach works by scanning stocks for certain attributes called risk factors and seeks to increase an investor’s exposure to those that they believe will deliver the best risk-adjusted returns.”

This is a stark contrast to that of traditional stock picking, where investors look at one company, analyze its financial accounts, and talk to management.

Dougan continued, “Five of the most common factors, momentum, volatility, size, quality, and value, are frequently used by investment managers to construct stock portfolios,” To which Dougan continued, “A listed company’s factor profile can, of course, change over time and many of these risk factors perform differently depending on the economic conditions.”

Factor strategies are growing in popularity as investors increasingly look more to education.

Dougan noted, “The approach is growing in popularity.”

FTSE Russell’s annual Smart Beta survey, which looked at whether investors are integrating factors into portfolios, revealed adoption by 58 percent of asset owners and other institutional investors globally in 2019, up 10 percent since 2018. And within this growing field, multi-factor-based investment approaches are also gaining traction.

So what about market access to these investment strategies? One way individual investors can gain exposure to risk factors is via ETFs, where a fund passively tracks its underlying index and is traded on exchange, much like a stock.”

🌎 Multifactor Exposure at Home and Across the Globe

To access multi factor exposure at home, investors can consider ETFs like WisdomTree U.S Multifactor Fund (BATS: USMF).

Here are some fund facts about USMF:

• Tracts the yield performance and price, before any expenses or fees, of the WisdomTree U.S Multifactor index.
• Typically, a minimum of 80% of the fund’s assets will be invested in component securities of the investments and index with economic characteristics like those of component securities.
• Generally, the index contains 200 U.S companies with the highest composite scores based on two technical (correlation and momentum) and two fundamental factors (quality measures and value) and 

On top of this, WisdomTree Investments offers multifactor ETFs that are actively-managed for international exposure.

Factor Investing Implications 

With more Americans looking to start new careers as day traders amid COVID-19, factor based strategies could be an ideal way to start. Factor based strategies allow you to gain factor exposures in a streamlined and targeted way.

Don’t be fooled into thinking that this will be a straightforward process. The world of factor investing is broad and reaches beyond the key factors highlighted in this guide.

In most cases, factor based strategies will expose you to a lot of factors within one structure. Others will expose you to the characteristics of different stocks that meet individual needs or goals, without explicitly increasing returns or altering the level of risk. 

More investors are utilizing factor investing, and strategies can be created and applied in significantly different ways which can affect their performance. As such, investors can find it difficult to navigate their way through the landscape.

For example, a factor based strategy that is created and implemented without any guidance or experience might be left exposed to some aspects that could affect the wider exposures of the portfolio. And remember, patience is key to finding the right deals when investing.

Furthermore, the definitions of factors, and which metrics capture these in the best ways which are still up for debate. Although factor-based strategies vary in their performance and should be given due consideration, the success of factors, and exposures as part of a wider portfolio is evident in academic research and historical performance.

About the author

Tim Fries

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Tim Fries is the cofounder of The Tokenist. He has a B. Sc. in Mechanical Engineering from the University of Michigan, and an MBA from the University of Chicago Booth School of Business. Tim served as a Senior Associate on the investment team at RW Baird's US Private Equity division, and is also the co-founder of Protective Technologies Capital, an investment firm specializing in sensing, protection and control solutions.