Factor Investing Definition Factor Based Asset Allocation

Factor Investing Definition

The factor which drives the returns can be style factors like value or macroeconomic factors like GDP. This factor-based technique forms the core of beta strategies which increases return on investments and lowers the risk in the long term. An example of the factor-based modelFactor-based ModelFactor Models are financial models that incorporate factors (macroeconomic, fundamental, and statistical) to determine the market equilibrium and calculate the required rate of return. They associate the return of a security to single or multiple risk factors in a linear model.read more describing the stock returns is the Fama–French three-factor model explaining returns with the market, value, and size factors.

Key Takeaways

Factor investing refers to a strategy that selects stocks based on a specific style or macroeconomic factors to enhance diversification and returns.The style factors are momentum, quality, value, size, and volatility. The macroeconomic factors are liquidity, credit, inflation, interest rates, GDP, etc.The concept started with or derived from the CAPM model, where the factor driving stock return is the market.Another pioneer model in the field is the Fama–French three-factor model explaining returns with the market, value, and size factors.

Factor Investing Explained

The factor investing method is derived from the Capital Asset Pricing ModelCapital Asset Pricing ModelThe Capital Asset Pricing Model (CAPM) defines the expected return from a portfolio of various securities with varying degrees of risk. It also considers the volatility of a particular security in relation to the market.read more (CAPM) developed in the early 1960s by William Sharpe, Jack Treynor, John Lintner, and Jan Mossin. According to the CAPM framework, systematic riskSystematic RiskSystematic Risk is defined as the risk that is inherent to the entire market or the whole market segment as it affects the economy as a whole and cannot be diversified away and thus is also known as an “undiversifiable risk” or “market risk” or even “volatility risk”.read more or market riskMarket RiskMarket risk is the risk that an investor faces due to the decrease in the market value of a financial product that affects the whole market and is not limited to a particular economic commodity. It is often called systematic risk.read more is the main factor determining the return on investment. Then evolved the Fama–French three-factor model explaining returns with three factors: market, value, and size factor. Later, researchers like Barr Rosenberg, Eugene Fama, and Kenneth French extended the CAPM to include certain systematic factors like value, small size, and momentum to explain the returns.

Deviating from the efficient market hypothesis, the following factors contributing to alpha generation can create a portfolio delivering excess returns overtime beating the market. Factors are categorized into style factors and macroeconomic factors. Popular style factors are value, size, quality, momentum, and volatilityVolatilityVolatility is the rate of fluctuations in the trading price of securities for a specific return. It is the shift of asset prices between a higher value and a lower value over a specific trading period. read more. The macroeconomic factorsMacroeconomic FactorsMacroeconomic factors are those that have a broad impact on the national economy, such as population, income, unemployment, investments, savings, and the rate of inflation, and are monitored by highly professional teams governed by the government or other economists.read more are GDPGDPGDP or Gross Domestic Product refers to the monetary measurement of the overall market value of the final output produced within a country over a period.read more, inflation, credit, interest rate, and liquidity.

Factor Based Investing Styles

Let’s explain the style factors used in factor investing based asset allocation in brief:

Value

The value factor suggests and identifies the inexpensive stocks, that is, the stocks with a low market priceMarket PriceMarket price refers to the current price prevailing in the market at which goods, services, or assets are purchased or sold. The price point at which the supply of a commodity matches its demand in the market becomes its market price.read more compared to their fundamental value derived from the books of accounts. It is identified using techniques calculating book to price, earnings to price, book valueBook ValueThe book value formula determines the net asset value receivable by the common shareholders if the company dissolves. It is calculated by deducting the preferred stocks and total liabilities from the total assets of the company.read more, sales, earningsEarningsEarnings are usually defined as the net income of the company obtained after reducing the cost of sales, operating expenses, interest, and taxes from all the sales revenue for a specific time period. In the case of an individual, it comprises wages or salaries or other payments.read more, cash earnings, net profitNet ProfitNet income for individuals and businesses refers to the amount of money left after subtracting direct and indirect expenses, taxes, and other deductions from their gross income. The income statement typically mentions it as the last line item, reflecting the profits made by an entity.read more, dividendsDividendsDividends refer to the portion of business earnings paid to the shareholders as gratitude for investing in the company’s equity.read more, cash flowCash FlowCash Flow is the amount of cash or cash equivalent generated & consumed by a Company over a given period. It proves to be a prerequisite for analyzing the business’s strength, profitability, & scope for betterment. read more, etc.

Size

Based on the market capitalizationMarket CapitalizationMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more size, there are small-cap and large-cap stocks. Based on historical data, small-cap stocks possess growth potential, higher risk, and return The drawback is that small-cap stocks are not well-known, are riskier, and may incur a loss, but there is always room for growth over time, which fuels high returns. So size factor focus on obtaining excess returns of small entities. It is identified using the market capitalization values available.

Volatility

The low volatility concept sticks to selecting low volatility stocks, which means stocks with relatively stable returns compared to the broader market. According to the low volatility anomaly, the low volatility stocks give higher returns than highly volatile stocks based on historical data analysis. It is identified using techniques like standard deviation, downside standard deviation, a standard deviationStandard DeviationStandard deviation (SD) is a popular statistical tool represented by the Greek letter ‘σ’ to measure the variation or dispersion of a set of data values relative to its mean (average), thus interpreting the data’s reliability.read more of idiosyncratic returns, beta, etc.

Momentum

The momentum factor directs to pick stocks based on the past performance. If the stock exhibited strong performance in the past, it is expected to continue its success in the future. It is identified using techniques like relative returns and historical alphaAlphaThe term alpha refers to an index that is used in a variety of financial models, including the capital asset pricing model, to determine the maximum possible return from a low-risk investment. Alpha of portfolio = Actual rate of return of portfolio – Risk-free rate of return – β * (Market return – Risk-free rate of return)read more.

Quality

The quality strategy selects the entities’ stocks with stable and strong financial performance, promising a regular return flow. Such companies are identified by determining ROEROEReturn on Equity (ROE) represents financial performance of a company. It is calculated as the net income divided by the shareholders equity. ROE signifies the efficiency in which the company is using assets to make profit.read more, earnings stability, dividend growth stability, balance sheet strength, financial leverageFinancial LeverageFinancial Leverage Ratio measures the impact of debt on the Company’s overall profitability. Moreover, high & low ratio implies high & low fixed business investment cost, respectively. read more, accounting policiesAccounting PoliciesAccounting policies refer to the framework or procedure followed by the management for bookkeeping and preparation of the financial statements. It involves accounting methods and practices determined at the corporate level.read more, management strength, accruals, cash flows, etc. It is one of the common factor investing elements used.

Example

Through single-factor and multi-factor indexes, FTSE Russell Factor Indexes provide exposure to the performance of six well-known stock market factors (quality, size, value, momentum, volatility, and yield). These six elements are determinants of stock market performance.

Let’s consider two groups. One with factors, value, and small size for selecting stocks. Value stocks exhibit a higher value based on accounts books than stock market values. Then, small stocks have smaller capital and outstanding sharesOutstanding SharesOutstanding shares are the stocks available with the company’s shareholders at a given point of time after excluding the shares that the entity had repurchased. It is shown as a part of the owner’s equity in the liability side of the company’s balance sheet.read more than other public listed companies. Another group contains growth and large stocks. Growth stocks are valued higher than their book values, and large stocks will have a significant market share.

Source: Forbes

From the above chart, if we compare value stocks to growth stocks (Russell 3000 value to Russell 3000 growth stocks) and small stocks to large company stocks (Russell 2000 small to Russell 1000 large stocks), it reveals the following:

In the aughts (2000-2009):

Value stocks and small stocks performed well Growth and large stocks showcased a poor performance

In the most recent decade, teens (2010-2019):

Growth stock outperforms value stockLarge outperformed small stocks