Have you watched one of the movies where the plot is tense, and there’s a tricky problem at hand, and suddenly someone applies data and pattern detection techniques and finds a solution?
Factor Investing applies the same logic for long-term investing. Factor investing uses data and algorithms to find distinguishable patterns in the market that can help us consistently outperform the market at low risk.
Different types of Investing Factors
Factors are indicators that can help describe stock returns. When you try to get into the details of the factors influencing market returns, you’ll find that they are very intuitive to understand.
Factor investing is a method that employs pre-set parameters, known as factors, to anticipate the performance of various assets such as stocks, bonds, or funds. These factors are categorized into two broad types - investment style factors and macroeconomic factors.
Factor-based asset allocation investing is a strategy that seeks to improve portfolio performance by investing in assets based on certain characteristics or "factors". These factors have historically been associated with higher returns. The goal is to construct a portfolio that aligns with these factors, aiming to drive positive returns.
Macroeconomic Factors Explained
Macroeconomic factors are broad events or conditions that significantly impact an economy, with repercussions across various asset classes. These factors can be fiscal, natural, or geopolitical and may affect a particular region, a nation, or the global economy at large. Some examples of macroeconomic factors include unemployment rates, inflation, interest rates, and GDP. These are distinct from microeconomic factors which are more focused on individual securities and include aspects like credit risk, liquidity, and stock price volatility.
Different Types of Style Factors
Style factors are more nuanced and are a quantitative way to describe strategies for outperformance. Style factors aim to account for returns and risks within specific asset classes. The five primary style factors - size, value, quality, momentum, and risk volatility - are considered by investors when evaluating various securities. Each of these style factors would have proponents among quantitative investors and all types of investors.
Size: Research has shown that smaller companies, often called "small-cap" companies, tend to produce higher returns than larger companies, or "large-cap" companies. This does not come without risk, however, as smaller companies can be more volatile and less stable than their larger counterparts. Despite this, the potential for high returns makes small-cap companies an attractive option for many investors.
Value: This factor is based on the principle that undervalued companies outperform overvalued ones. Value investors seek stocks that are trading for less than their intrinsic value, determined by metrics such as the price-to-book value ratio, price-to-earnings ratio, and dividends. Essentially, value investing is about finding and buying stocks that are "on sale".
Quality: This factor focuses on companies with high-quality earnings, signifying strong financial health. Such companies often have low debt, stable earnings, and consistent growth. They're also typically efficient with their use of capital. Quality investing is about finding companies with solid financial foundations that are likely to be profitable in the long term.
Momentum: This factor is based on the trend of a stock's price. It posits that stocks that have been performing well recently are likely to continue doing so in the near future. Momentum investing involves buying stocks on an upward trend and selling them when they appear to have peaked.
Risk Volatility: This strategy aims to create a portfolio that has the lowest possible volatility. The goal is not necessarily to enhance returns but to decrease risk. By investing in stocks that have historically demonstrated lower volatility, the portfolio is expected to experience smaller fluctuations, which can be beneficial for risk-averse investors. High volatility stocks, which have historically had lower realized returns, are often excluded from such portfolios.
The effectiveness of these factors can depend on the holding period. Longer holding periods often increase the probability of success, as market fluctuations tend to even out over time. And factor investing strategies can be a gamechanger for long-term performance. While the Nifty 50 Index has given around 10% CAGR since 2010, most factor strategies have a much higher return.
As with any investment strategy, it's crucial to carefully consider one's individual financial situation, risk tolerance, and investment goals.
It's important to note that these factors aren't guarantees of success; they simply provide a structured approach to portfolio construction based on historical data. Additionally, while these factors can improve the potential for positive returns, they also carry their own risks and should be used as part of a well-diversified investment strategy.
% of rolling periods factors outperformed their counterparts
Benefits of Factor Investing
Factors allow investors to find stock themes that fit their risk appetite and enable them to invest in a unique opportunity. Investors can get exposure to multiple factors, thus increasing their diversification and consistency or returns. Tactical allocation to Factors, while challenging, can be highly lucrative.
Factors being data-driven can focus on a broad universe. They capture all significant fundamental anomalies in the market and behavioral biases. They allow the investors to get greater diversification, thus lowering their drawdowns.
Factors can be served in a passive or an active basket. As these baskets are data and technology-driven, they have low expense ratios.
Risks of Factor Investing
Factor returns can be cyclical , and any factor will not work all the time. On the other hand, a single factor can have extended periods of underperformance like the value factor had in the last couple of years when Momentum outperformed.
So, it is always a good idea to trust an investment advisor that guides you with a tactical allocation to factors. Factor maths is also quite complex, so investors should generally trust practiced researchers in the field.
Factor Investing in India
The NSE has published factor Indices since 2017, and there are some ETFs available for the same as well. In addition, Robo-advisors like Wright Research also publish curated factor or smart beta strategies, which are very popular on smallcase. Explore market indices & factors here
Talking about the relative performance of Factors in India, Momentum or Trend Following has always been an influential factor for Indian investors because India has gone through strong growth markets.
Quality is also a factor that works well in India, along with Size or betting on smaller stocks.
In times of volatility, Value or Low Volatility factors outperform the market.
Read about the risks and rewards associated with factor investing .
Visit Wright's Balanced Multifactor portfolio.