Factor Investing: The Key to Smarter Investing
Factor investing is a type of investment strategy that involves grouping stocks together based on certain common characteristics, such as fundamental balance sheet items, management style, market capitalization, historical performance, and statistical properties of stock returns. These characteristics, known as factors, are used to create portfolios that are believed to offer consistently high risk-adjusted returns and diversification benefits for investors. Factor investing allows investors to focus on specific factors that have been shown to offer potentially superior returns over time, rather than investing in the overall market or a simple index tracker.
The most common style factors used in factor investing include value, quality, size, low volatility, and momentum. These factors are based on fundamental or price data and can be applied to the entire universe of active securities, making them suitable for large-scale investment and easy to implement for both large fund managers and individual investors. Other well-known factors include reversion, short interest, seasonality, and earnings yield. It is important to note that style factors have the ability to handle large investment capacity and still deliver excess returns, making them an attractive option for investors seeking consistently high risk-adjusted returns.
Investment capacity of style factors as calculated by Blackrock in "Capacity of Smart Beta Strategies: A Transaction Cost Perspective"
Style factors are characteristics used to group stocks together in investment portfolios. These characteristics, or properties, can include a wide range of factors, such as:
Fundamental balance sheet items: These are financial metrics that reflect the financial health and stability of a company, such as its debt levels, profitability, and return on equity.
Management style and governance: This refers to the way a company is managed and governed, including factors such as the experience and track record of the management team and the quality of the company's corporate governance practices.
Market capitalization and price metrics: These factors refer to the size of a company, as measured by its market capitalization, and various price metrics, such as its price-to-earnings ratio, price-to-book ratio, and price-to-sales ratio.
Historical performance: This refers to the past performance of a stock, including its return on investment, risk profile, and volatility.
Statistical properties of stock returns: This includes a range of statistical measures, such as the average return, standard deviation, and skewness of a stock's returns.
By grouping stocks together based on these characteristics, investors can create portfolios that are believed to offer consistently high risk-adjusted returns and diversification benefits.
Brief history of style factors
Style factors, or characteristics used to group stocks together in investment portfolios, have a long history in the financial markets. The concept of using style factors to achieve diversification and excess returns can be traced back to the 1950s, when financial researchers first identified the value premium, or the tendency for value stocks (those with a low price-to-book ratio) to outperform the overall market.
In the 1980s, the concept of style factors was further developed with the introduction of the three-factor model, which added the size factor (market capitalization) and the value factor (price-to-book ratio) to the traditional market factor (market index). The three-factor model was expanded in the 1990s to include the quality factor, which measures the financial strength and stability of a company.
Since the early 2000s, the use of style factors in investment strategies has gained widespread popularity, particularly with the rise of smart beta and factor-based index funds and ETFs. Today, style factors are widely used by investors as a means of achieving diversification and excess returns in their portfolios.
Style factors can be used to achieve specific investment goals, such as focusing on value or momentum stocks.
Small investors or retail investors may use style factors to construct portfolios that align with their preferences.
Investors can use style factors to tilt their portfolios towards specific characteristics.
Style factors can be used to analyze and mitigate risk in portfolios by adjusting factor exposure.
Hedge funds may use style factors to construct strategies with limited exposure to these characteristics.