Factor investing is increasingly gaining popularity. Financial magazines run features on it, seminars are organized on this subject and investors are looking to adopt this approach.
But is the growing interest in factor investing just a passing trend? This obviously demands an answer since investors are attracted to trends. But before we answer that we need to understand what factor investing is.
Factor investing is a strategy in which you strategically invest in certain characteristics of securities to get better return in the long run. These characteristics were identified in leading academic studies from 1970 onwards which showed that value, momentum, small cap and low volatility stocks systematically generate higher risk-adjusted returns.
Basically, factor investing is an investment strategy that goes one step beyond asset diversification. In this approach, we do diversification based on stock attributes. It requires investors to be more specific before selecting any security.
History of factor investing
Research on factor investing started in 1970 when academics started to question the CAPM (Capital Asset Pricing Model) model. CAPM model helps us calculate the investment risk and what return we should expect. CAPM has two risks associated with it: 1) systematic risk which cannot be diversified 2) Unsystematic risk which can be diversified.
In 1972, two academic scholars Robert Haugen and James Heinz studied the returns of the stock and came to a very surprising conclusion. They concluded that the relation between the risk and return is not linear at all as low risk stocks (low volatility) actually give better returns than one would have expected.
Other proponents of factor investing also questioned CAPM model and in 1990 two academic reports showed that small cap and value stocks performed marginally better that the markets/index. In fact, a study proved that certain parts of the market can yield higher returns and not all returns depend on the prevailing risk.
In 1990, more building blocks to factor investing were added. Academics proved that past leaders and performers can be future leaders and performers too; this came to be known as momentum effect.
Though theories and research proved that investors would benefit from investing in attributes in the long run, investment managers were very slow to adopt this strategy and the concept became popular only after the crash of 2008.
Attributes of factor investing:
- Value: It is the intrinsic value of the stock or real worth of the stock. When intrinsic value is lower than the market value you buy the stock after considering other factors. You can value it by looking at Price/BV, Price/EPS, Price/sales etc. depending on the stock and sector.
- Small Cap: Stocks with relatively small market cap as compared to their peers. We do need to consider the company’s financials and forward outlook before investing.
- Momentum: Reflects excess returns to stocks with stronger past performance. One can look at relative returns quarterly/annually before making a decision.
- Low Volatility: Captures excess returns to stocks with lower than average volatility, beta and systematic risk. One can understand volatility via standard deviation of returns.
- Quality: Captures excess returns to stocks that are characterized by low debt, stable earnings growth and other quality metrics. One has to look into company ROE, earnings stability, strength of balance sheet, financial leverage etc.
Conclusion
Factor investing has gained ground due to decades of research and the empirical evidence is still growing.
Now, institutional investors have already started adopting factor based investing. For instance, index provider MSCI Inc. has developed indices by incorporating the above mentioned six characteristics. Fund houses such as Canara Robeco and Motilal Oswal also use certain attributes of factor based investing approach.
Let us know if you would like to know anything more!