Investing is no rocket science, but it appears that there is empirical evidence that there are some consistent drivers predictive of higher long-term returns when investing.
Traditional investment approaches have bordered mainly on alpha and beta investment strategies, i.e. active and passive investments with decades of financial research and theory behind them. They have provided the foundation in financial theory for investors to take additional risks to gain excess returns.
If you don’t already know, active investing strategies are more hands-on and they try to outperform the market. They use their expertise to pick the right combination of stocks and find the right market entry and exit points to make excess returns known as alpha. This outperformance could be due to luck or skill of the portfolio manager (sometimes even unpublished information).
Passive investing strategies on the other hand, do not attempt to outperform the market but instead, attempt to track a broad market index or benchmark through a low cost investing strategy (typically buy-and-hold) through an index fund or ETF.
While the active versus passive argument when investing has been debated to death, there is however, evidence that securities can also be chosen based on certain systematic characteristics – known as factors – that have shown themselves to be complementary to the traditional two investment approaches; providing investors with higher risk-adjusted returns in the long run.
Factor-based investing takes some sort like a middle-approach – it combines elements of both active and passive investing by using a rules-based and systematic approach to select investments to be included in a portfolio.
In contrast to traditional market capitalization-weighted approach to stock selection in traditional indices, a style factor-based approach could incorporate other characteristics such as dividend growth or profitability to decide a stock’s weight in the factor index.
Style factor investing is one popular form of factor investing – the other being macro factor, which uses macroeconomic data and business cycles to shape security selection.
Style factors further explained
Style factors include characteristics such as value, size, momentum, volatility and quality.
The value factor is used to find stocks which exhibit value characteristics, which can be defined in many ways, and one common way is to find stocks which are priced at a discount to their true value or their peers – i.e. cheap, from the perspective of the investor.
Some common ways to determine how cheap a stock is include screening for stocks with high price-earnings ratio, low price-to-book ratios and high dividend yields.
It is assumed that stocks which are priced cheaper will deliver higher returns. Of course, this might be a flawed assumption as it isn’t always true that paying $0.90 for a $1 stock is always a good buy – the price should not be the sole determinant of your investment decision.
The size factor is used to find stocks which are smaller such as small cap stocks, which are poised to outperform larger companies due to their more rapid growth prospects.
The momentum factor is used to find stocks that exhibit positive price momentum, i.e. stocks which have performed well over the previous months. This factor is based on the premise that stocks which has performed well previously will continue to perform well and conversely, stocks which has performed badly will continue to perform badly.
This assumption could be true due to behavioural biases from investors such as herding, which pushes prices up the trend further.
The volatility factor is used to find stocks that are have low standard deviation (less fluctuations) or lower volatility (low beta) characteristics, relative to the broader market. This factor has been proved to show more muted drawdowns when the broad market tanks.
Historically, low volatility stocks have outperformed the market – despite contradicting financial theory that higher returns can only be obtained through higher levels of risk taking.
Finally, the quality factor is similar to the value factor, and screens stocks with higher quality attributes and durable competitive advantages such as returns on equity, earnings quality and low debt.
Isn’t factor investing like stock selection?
While there are some overlaps between factor investing and stock selection when screening for securities to invest in, the main difference is that factor investing involves a systematic, rules-based approach to stock selection using available quantitative data. The process also involves investing in a basket of securities that exhibit these criteria.
On the other hand, stock selection tends to be concentrated towards a single or a few stocks. The performance of stock selection is also typically based on the skill of the investor and ability to obtain superior information quickly, which are inherently difficult.
As a result, factor investing can be used consistently over time to replicate results pervasively in a portfolio.
Using factors in your portfolio
Implementing factors in your portfolio can be as simple as buying up a factor or smart beta ETF.
In fact (pun intended), US factor ETF growth has grown phenomenally over the years, reaching US$482B in October 2019.
For example, investors who love finding US stocks that exhibit value characteristics such as low P/E ratios can buy up the iShares Edge MSCI USA Value Factor ETF (VLUE) with an expense ratio of just 0.15%.
There is a fundamental truth, no factor consistently outperforms its benchmark every year
There are close to 1000 factor ETFs available, investors have tons of options to construct a suitable portfolio for themselves.
You don’t have to replace your entire portfolio with factor-based strategies – you can complement your existing passive or active investment strategies with factor strategies to deliver higher risk-adjusted returns at lower costs compared to active fund management or stock picking.
There are also multi-factor strategies available for you to diversify across factors!
Factor investing vs market-cap portfolios
Market cap weighted indices reflect the aggregate holdings of all investors in the entire investable opportunity set, which factor investing does not offer.
Instead, factor investing are active tilts away from market cap weighted indices which perform differently at different phases of the economic cycle. For example, quality and low volatility factors tend to perform better when the economy is weak.
I personally have added factor-based investing to my portfolio
While I am an advocate of portfolio simplicity, I am also convinced about the benefits of factor-based investing.
In my DIY portfolio, I’ve added one minimum volatility ETF to complement my core portfolio holdings in light of the heightened volatility environment.
I’ve also started using Endowus as a robo-advisor for investment access to Dimensional Fund Advisors‘ global passive funds (TER: 0.43%), which are Ireland-domiciled, accumulating funds and have tilts towards stocks with profitability, value and size factors.
Of course, this thousand-word article should just be an introduction to the exciting world of factor-based investing, which is empirically-driven and simple to implement at a low-cost – regardless of whether you’re already using active or passive investing approaches.