The Factor That Matters – About Factor Investing

In life, as well as in investments, you first need to identify your goals and then determine the things you need to do in order to achieve those goals. One of my perennial goals in life is to lose weight. I go about this in a very systematic manner, identifying the nutrition that I need and then consuming foods that are high in the various types of vitamins and supplements that my body requires. Another important goal for me is to create and maintain a well-diversified portfolio that is capable of meeting my return expectations within my risk capability. This, ofcourse, is easier said than done.

When it comes to creating an optimal portfolio, we must focus on the factors that impact our investments and influence our investment decision making. When you look at a stock through a magnifying glass, you will see that there are various factors which impact its performance. These factors tend to capture the main characteristics of a stock and can often be a source of equity risk premia. Factors are integral to the performance of a stock and identifying stock specific factors can go a long way in helping investors determine the true source of stock returns.

Why Factor Investing Works

Factors are fundamentally broad, persistent characteristics that can both impact and drive asset returns. They are generally persistent over time and have consistently demonstrated an ability to explain stock returns. Over the last 50 years, academic research has identified hundreds of factors that impact stock returns. Knowing these factors and exposing your portfolio to such factors, can help investors generate alpha. Factors are the foundation of investing just as nutrients are the foundation of our food.

Types of Factors

There are two main types of factors: i) Style factors – these capture risk within asset classes and ii) Macro-economic factors – these capture broad risks across asset classes

Style factors is something that most of us are already conversant with. After all, many of invest according to market cap (size factor) or prefer to buy stocks at compelling valuations (value factor).

Popular style factors that can capture stock specific risk:

- Value – this factors captures the excess returns of stocks that are available at a discount to their fundamental value.

- Yield – this factors captures the excess returns of stocks that have a high dividend yield

- Momentum – this factors captures the excess return of stocks that tend to perform in high momentum markets

- Quality – this factor captures the excess return of stocks that have good quality earnings and stable growth.

- Low Volatility – this factor captures the excess return of stocks that have lower than average beta/volatility.

- Size – this factor captures the excess returns of stocks basis their market capitalisation.

Macro factors are those related to economic growth, interest rates, inflation and liquidity, among others. The ability to identify these factors means understanding the actual source of return of a stock. This can be highly potent for an investor.