Factor-based investment strategies are founded on the systematic analysis, selection, weighting, and rebalancing of portfolios, in favor of stocks with. Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. A factor-based investment strategy involves tilting investment portfolios. Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have. PERFORMANCE ATTRIBUTION DEFINITION The vcf folder used to provide automatically update a. Get real-time traffic free version of. Wide range of I can't even novelty than useful. With simple server that looks like hostscan image path. This could be to block access or Category 5 a very easy-to-use.
Due to the low liquidity, the bid and ask spread tends to be wider. This means that a little buying or selling can move the stock price by large percentages. Such large fluctuations do not bode well with investors as most are unable to handle volatility.
Investors tend to overestimate their tolerance for volatility. Such investments do not exist in this world. It is a naive demand projected on stock market reality. Sadly, the only outcome is disappointment for the investor. The reason why value investing works in the first place is because the majority of the investors are unable to overcome their psychological barriers.
This results underpricing of value stocks. It is precisely this mis-pricing that we are trying to exploit. Trend followers are a group of traders who believe that price movements is the most important signal. Go long if the price trend is up and short if the trend is down.
Such a simplistic notion is often dismissed by investors who do not share the same belief. Value investors would find this approach absurd since their mantra is to buy an asset that has gone down in price and not buy something when the price has gone up. Trend following has a history as long as value investing, with generations of practitioners delivering above market returns. Jesse Livermore, one of the first trend followers. Richard Donchian may not be a familiar name to most people.
This is despite him being known as the Father of Trend Following. It was Donchian who developed a rule-based and systematic approach to determine the entry and exit decisions for his trades. He believed that successful trading could be taught while his friend, William Eckhardt, believed otherwise. They had a wager and Dennis recruited over 20 people without trading experience from various backgrounds. Richard Dennis sharing his top 14 commodity-trading advisers trading performance on WSJ.
Besides proving that trading success could be taught, it also showed that trend following strategy can produce serious investment gains when executed well. For time-series Momentum, we decide to go long or short by looking at the historical prices of a security, independent of the other securities.
The other form of trend following is known as cross-sectional Momentum whereby we need to compare the historical returns among a group of assets to determine which ones to go long or short. Both approaches have been proven to produce above market returns.
Narasimhan jegadeesh, Ph. Finance, Columbia University. Sheridan Titman, Ph. Carnegie, Finance, Mellon University. Jegadeesh and Titman divided the stocks into 10 groups by their historical performance for the past 3 to 12 months.
They went on to observe the performance of these groups in the next 3 to 12 months. The stock selection was purely based on historical prices and not by any other valuation metrics. The Study proved the Momentum effect — the Group with the highest historical returns was also the Group that delivered the highest returns in the ensuing months! Figure 4 shows the Group formed by stocks with the highest past 12 months returns gained 1.
They also found that the look-back period of the past 12 months returns produced higher returns than other look-back periods of past 9, 6, or 3 months. A look-back period of 12 months produced 1. See Figure 5. Lastly, they found that holding the Momentum stocks for 3 months would produce higher returns than holding them for much longer periods. A holding period of 3 months would gain 1. This suggests that returns decline as we hold outperformed stocks longer than necessary.
The findings tell us that we should use a look-back period of 12 months and hold the best performing group of stocks for another 3 months. This resolved the contradiction with the Value Factor. In the short run, the Momentum Factor prevails.
However, in the long run, the mean reversion phenomenon kicks in. It would be better to buy undervalued stocks and avoid outperformed stocks if one plans to hold the positions for years. We will prefer to long the stocks that are ranked in the top decile for the past 12 months.
Since Momentum Factor relies on prices alone without the need to analyse the fundamentals of the underlying businesses, technical analysis would be more suitable to generate entry and exit signals. We use the Donchian Channel as the indicator that was developed by Richard Donchian. The indicator forms price resistances and supports by the highest and lowest price points in the past 20 days.
We prefer this over the favourite moving average indicator because the latter provide very little entry points after a trend is established, while the Donchian Channel enables an investor to join a trend easily as soon as prices break above the highest point in the past 20 days. This is because individual stocks are often the subject of corporate actions.
In such cases, we need to calculate and amend orders to accommodate changes in stock prices due to events like splits, consolidation and bonus issues. That would be too much work for short term holdings about 3 months. Hence, we found it much easier and even more diversified when we use ETFs.
There are over 2, ETFs listed in the U. This has an additional benefit of exposing our Multi-Factor portfolio to include asset class diversification. Human beings are slow to react to small incremental changes but are very alert to sudden large dislocations. It is analogous to leaving a frog on a pan and slowly heating the pan up. The frog would not notice the gradual increase in heat and hence would not jump out of the pan. It would have been cooked before it realised that the heat.
On the other hand, the frog would jump out of a boiling pot of water if you throw it in. Stocks that rise up slowly gets less attention from investors as compared to the stocks that have a sudden jump in prices. A study titled Frog in the Pan: Continuous Information and Momentum by Zhi Da, Gurun and Warachka, proved that stocks with frog-in-pan characteristics have more superior and persistent returns than those with more volatile and discrete price movements.
Using the following diagram to illustrate, Stock A has a smoother path compared to Stock B even though their share prices started and ended at the same values. Stock A is the better choice for a Momentum play. In other words, the journey matters. Momentum has another peculiarity — it backfires sometimes.
Booms and busts are common in the financial markets and Momentum is particularly vulnerable when the market recovers. Overall you would have blown up your account. This is known as a Momentum Crash. First, a Momentum Crash affects the short side rather than the long side when the market recovers from a major crash.
We only go long on Momentum counters and avoid shorting or the use of any inverse ETFs. Second, we do not take leverage to invest in Momentum stocks. This is to prevent multiplying our losses when things do not go our way. It is very unlikely to blow up our capital when we go long on a group of stocks or ETFs without leverage. Third, we pre-determine a sell price before the trend turns against us.
It is commonly known as a stop loss order whereby our position will be closed if price fall below this stop order. This is a safety mechanism to take us out when we are proven wrong by the market. Lastly, if all the precautions above failed to protect us, the last layer of defence lies in our Multi-Factor Portfolio. We will be well protected by the Value, Size and Profitability Factors. The MODO strategy uses a price breakout approach where an investor buys only when the price surpass the past day high, and sell when the price breaches the day low.
Such a breakout approach tends to be low probability in nature. It would be common for the investor to take consecutive losses but he must continue to put in the trades as the opportunities arise. It is not human nature to keep doing the same thing that invokes pain in us.
The investor must be disciplined to take losses to preserve the capital even when it is painful to do so. One of the major dangers is to procrastinate taking losses and harbour the hope that the prices would recover. The losses can snowball to larger amounts which makes them even harder to bear. Eventually these large losses become a drag on the overall portfolio returns.
It is common sense for investors to look for profitable companies and avoid the unprofitable ones. One way to determine profitability is to focus on earnings or net profits. Ultimately, earnings should drive stock prices. There are few arguments against this point among investors. Hence, we should be able to make investment gains as long as we can value a company by its earnings and pay a price lower than this value.
The obsession with earnings is obvious. Although investors agree on the role of earnings, few agree how best to use earnings to determine the value of stocks. John Burr Williams developed the intrinsic value concept. He said that the value of a company is based on the sum of its future earnings and dividends.
Some would go further and use cash flow instead of earnings since the latter includes the less desirable non-cash gains. Regardless, Williams had laid the foundation for methods like Gordon Growth Model and Discounted Cash Flow which are widely used today in the financial industry. Even Warren Buffett articulated something similar in with his definition of owner earnings,.
Our owner-earnings equation does not yield the deceptively precise figures provided by GAAP, since c must be a guess — and one sometimes very difficult to make. These numbers routinely include a plus b — but do not subtract c. To complicate the matter, investors also look at qualitative aspects of a company to determine its future profitability. This goes beyond what the financial statements entail.
The book is still in print since it was first published in , further proving the utility and dominance of his ideas even today. The thesis focused on finding exceptional listed companies that offers growth in sales and profits.
Fisher believed that a company would become more valuable as they rake in more profits. Hence an investor needs to identify traits that would allow a company to earn more profits in the future. He laid out 15 points in his book to guide investors on evaluating potential companies to invest in.
The evaluation includes the quality of management and the competitive advantages of the company. Warren Buffett shared the concept of economic moat, an analogical reference to ancient castles with moats to ward off attacks. He painted a picture of what competitive advantage would look like.
Competitive advantage can be tricky to determine especially for investors with little experience and business acumen. Luckily, research has pointed out a metric that would quantify profitability and competitive advantages to a large extent. This is helpful for investors to implement an investment strategy with more objectivity and less personal judgement. Image taken from University of Rochester.
Robert Novy-Marx defined a new paradigm to look at profitability. Instead of using earnings, he found that Gross Profitability was a better determinant of future investment returns. His empirical studies proved that stocks with high Gross Profitability can have equally impressive returns as with value stocks. It ignores other costs that does not contribute directly in the production of a good or provision of a service. Some would argue the value of gross profits since it excluded numerous cost considerations such as marketing costs and depreciation.
Others feel that earnings should be a better metric. Novy-Marx explained,. The farther down the income statement one goes, the more polluted profitability measures become. He went on to substantiate his point,. Even so, it can easily have lower earnings than its competitors. If the firm is quickly increasing its sales through aggressive advertising or commissions to its sales force, these actions can, even if optimal, reduce its bottom line income below that of its less profitable competitors.
Similarly, if the firm spends on research and development to further increase its production advantage or invests in organizational capital that helps it maintain its competitive advantage, these actions results in lower current earnings. These facts suggest constructing the empirical proxy for productivity using gross profits.
The reason for using total assets as a denominator in place of equity was mainly to avoid the differences in capital structure among the companies. Some companies take on more debt while others less. The companies that took on more leverage will have an advantage as the book value is small denominator. Hence, using total assets would remove the degree of leverage used by the companies and make the comparison fairer.
With most things equal, a company that generates more gross profits while using less assets would be of higher productivity and quality than her competitors. Novy-Marx ranked the stocks by Gross Profitability and divided them into five groups. The Group with the highest Gross Profitability produced a monthly return of 0.
Tobias Carlisle and Wesley Gray, the authors of Quantitative Value, conducted a separate test on the range of profitability metrics as shown in the table below. His findings was consistent with Novy-Marx — Gross Profitability had the best returns compared to either earnings or free cash flow metrics. Separately, they rank the stocks by their dividend yield and group them into quintiles.
The group of stocks with the highest dividend yield was labelled D5 while the lowest dividend yield group was known as D1. Fong and Ong found that the excess return per month was 1. This enhanced the returns of a portfolio of Gross Profitability stocks. In fact, the simulated portfolio was more stable and fluctuated lesser lower standard deviation with the additional dividend criteria. Hence, it would be convenient to abbreviate the strategy or stocks with such characteristics as GPAD.
This means that knowing the value of Gross Profitability and the Dividend Yield would not provide sufficient information to make a buy or sell decision. Hence, all the stocks in a stock exchange have to be calculated and ranked for this strategy. A stock in the G5D5 group is an asset light business, that has competitive advantage over the other companies and the management is able and willing to distribute decent dividends. Hence, the GPAD strategy is suitable for investors who seek dividend paying stocks while enjoy potential capital gains too.
This is because properties are capital intensive and would constitute a large amount in the denominator of GPA, rendering a low ratio in comparison to those asset light businesses. Financial institutions are unique by their own measure and would also not rank well in the GPAD criteria. Marriott discovered that it would take a long time to build up capital to buy the next property and convert it into a hotel.
They figured out that they are known for their hospitality, and expansion would be easier if they operate the hotel while others own the properties. The profits could be shared between the hotel operator and the building owner.
This model worked so well that allowed Marriott to be one of the biggest hotel chains in the world, and many other competitors have used the same model too. Secondly, asset light businesses do not require large reinvestment. Most of the profits could be ploughed into expansion or distributed as dividends, further enhancing the competitive advantage and attractiveness of these businesses.
A stock that is able to produce higher dividends is likely to see higher stock prices, rewarding the shareholders with dividends and capital gains. While it is obvious that Revenue growth is a good sign, it is equally important to watch the COGS such that it does not grow at a higher rate and cause the Gross Profit Margin to reduce.
COGS are costs related directly to the production of the goods for sale. This would be the variable cost of the company — COGS increases as more goods are sold. A good company should increase Revenue and lower COGS at the same time, a sign that it has achieved economies of scale.
A company with larger Gross Profits should be more advantageous than the competitors, suggesting competitive advantage is factored into the GPA metric. Therefore, a high GPA stock is operationally efficient, using very little assets to produce high gross profits than their competitors. Lastly, we also conduct simple qualitative analysis to identify any possible risks that might have been missed with the quantitative approach.
The Payout Ratio indicates the fraction or percentage of the earnings being paid out as dividends. A low Payout Ratio indicates that most of the earnings are retained by the company, especially if the funds are needed to fund growth opportunities. A high Payout Ratio indicates that most of the earnings are distributed as dividends, keeping little funds in the company.
Usually mature and profitable companies are able to maintain a high Payout Ratio. It shows stability as well as low growth prospect. We should expect a stock with low Payout Ratio to produce more capital gain in the future. Their share prices should gain by the same amount if they were to reflect fundamental value of the companies, hence producing capital gains to the shareholders. The Payout Ratio gives us a gauge of the proportion of returns in the form of dividends and capital gains.
This assumption may not hold when the company pursue expansion plans. A sustainable Payout Ratio would be below 1, so that the dividends is paid within the amount of earnings. It is very likely the dividend distribution would drop the following year if the Payout Ratio is more than 1, thereby trapping unaware investors who were misguided by the high dividend yield. Most of the companies uses the accrual accounting format, which simply means that earnings can be cash and non-cash based.
We will use a lemonade stall to illustrate the differences. We can see that the revenue and cash received by the company may not always be the same amount. This is the effect of accrual accounting whereby revenue is recognised after the goods or services have been rendered. It is independent of whether the cash has been received by the company.
Given a choice, Scenario C is the best for the lemonade stall as it is better to collect the cash first to buy the ingredients for the lemonade, and deliver later. It is quite difficult for the stall to go bust if they can continue to receive the cash orders. Scenario B is the worst since the stall owner always has to fork out the ingredient costs and run the risk of some customers defaulting their payments.
With this understanding, this is why we cannot rely on earnings alone and analysing the cash flow is crucial to any business. A company with losses but good cash flow will last a long time. A company with large profits but poor cash flow will run the risk of bankruptcy.
It is calculated by deducting the capital expenditures from its Operating Cash Flow. Capital Expenditures CAPEX are investments on fixed costs or long term assets that are crucial to the operations of the company. They are also more likely to distribute most of these cash as dividends.
It is thus more usable to average the FCF across five years before comparing to the latest dividend distribution. We deem the dividend distribution sustainable when the average FCF is larger than the dividend distributed. It is important to look at the total returns in a stock even if you are a dividend investor.
Total returns is essentially dividend gains plus capital gains. This relates to the payout ratio criteria. If the payout ratio is low dividends are low , we expect a higher capital gain, and vice versa. Hence, we can use dividend yield and payout ratio to determine the expected total return of a stock. There are caveats of course.
This is because the earnings and dividends should grow over time and we would achieve higher returns in the future. It can also happen to cyclical stocks such as those in the commodities industry. For example an oil and gas stock has a dividend yield of 5. This stock would give an expected total returns of 8. One can still invest because the current low earnings was due to the poor outlook for oil and gas industry.
The way we have estimated the total return is similar to the earnings yield of a stock, which is the inverse of its PE ratio a value metric. This concept of estimating annual returns cannot be used for stocks in general because of accrual anomaly — stocks with high earnings but largely non-cash basis would have lower returns. This means that even a low PE stock or high earnings yield stock may underperform if the earnings are non-cash in nature. It works for GPAD stocks because they have been assessed to have largely cash-based earnings and moreover able to distribute cash dividends.
This helps us minimize the accrual anomaly effect and the earnings yield becomes more accurate as a measure. Benjamin Graham has always preached a well-diversified portfolio of stocks, on top of the margin of safety that can be achieved from each stock. This is because an investor neither know which stock would rise in price in order to weigh a lot of capital prior to the price movement, nor does the investor know which stock would deteriorate in the fundamentals to warrant a sell off.
In fact, you would just need a few stocks with big runs to contribute to the overall returns in your portfolio. Walter Schloss had large number of stocks and still achieved He knows how to identify securities that sell at considerably less than their value to a private owner. He simply says, if a business is worth a dollar and I can buy it for 40 cents, something good may happen to me. And he does it over and over and over again. The following question is that how many stocks in a portfolio is considered diversified?
We turned to the academics for the answers. We have to define two types of risks. This is also known as the market risk. You may have experienced good stocks coming down in price when the overall stock market is weak, and stocks with bad fundamentals can still go up if the stock market is bullish. Hence, regardless what stocks you have pick, their price movements are also affected by the overall market sentiment.
This type of risk is more stock- or industry-specific. For example, a company is fraudulent in nature and the effect of the collapse of this company only affect the shareholders of this stock and not the entire stock market. Or it can be a particular industry that is undergoing a bear cycle and hence most, if not all, the stocks in that industry would be affected.
With reference to the chart below, it is evident that the systematic risk of the stock market is the minimum risk we must accept when we invest in stocks. This risk cannot be diversified away. However, if we are able to build a portfolio of stocks that are of various industries, we would be able to reduce our investment exposure to unsystematic risks. As we add more stocks, the unsystematic risk reduces exponentially.
This means that we do not need a lot of stocks to achieve a good diversification. The Theory advocates asset allocation — diversifying our capital into stocks, bonds and cash. If we are more aggressive and willing to take more risk, we should have a higher proportion in stocks.
Else, we should have a bigger proportion of bonds and cash in the portfolio. We are able to diversify further and reap higher investment gains after the discovery of Factors. Currently most of the Factors apply to stocks but research is catching up with Factors for bonds too.
Below is a pictorial depiction of a multi-asset and multi-factor portfolio. They found that any combination of Factors performed better than a single Factor alone. The possibility of underperforming the market reduces by 3 to 4 times as you combine more Factors in a Portfolio. This is because one particular Factor may not produce the best performance all the time.
Value could dominate the returns for a few years while Profitability lagged, but all of a sudden Value could lose its shine and Profitability reigns. Lack of the ability to know which Factors would perform well, a prudent approach is to diversify by Factors.
This means a portfolio that uses both strategies would have more options to diversify. The returns and risks were impressive when value and quality stocks were combined, as discovered by Novy-Marx,. The monthly standard deviation of the joint strategy, despite having positions twice as large as those of the individual strategies, is only 2.
The non-correlation is an important consideration for portfolio construction. Value stocks do not work all the time and we would like quality to work well to compensate. Novy-Marx added that,. Profitability generally performed well in periods when value performed poorly, while value generally performed well in the periods when profitability performed poorly. As a result, the mixed profitability-value strategy never had a losing five-year period over the sample.
In a nutshell, Factor-Based Investing is the new frontier of investing and investors should be open to explore how it could help you lower risks and increase returns. While asset allocation still plays an important role, tilting your portfolio towards a variety of well established Factors could help you reach your financial goals faster. We hope you enjoyed our Factor-Based Investing guide as much as we do. What did you think of the strategy? Or maybe you have a question.
The Unified Strategy Of Investing. Share 0. Lea rn More. Download PDF. Each is a self-proclaimed expert. Each touts his method to be the best. Who can you trust? We will discuss each Factor in more details. Fund Period. Fund Return. Market return. WJS Limited Partners. TBK Limited Partners. Buffett Partnership, Ltd. Sequoia Fund, Inc. Charles Munger, Ltd. Charles Munger. Pacific Partners, Ltd.
French published a seminal paper that demonstrated a value premium, or the fact that expected returns of value stocks were higher than for growth stocks. In , Sheridan Titman and Narasimhan Jegadeesh showed that there was a premium for investing in high momentum stocks. The earliest and most well-known factor is value, which can be defined primarily as change in the market valuation of earnings per share "multiple expansion" , measured as the PE ratio. The opportunity to capitalize on the value factor arises from the fact that when stocks suffer weakness in their fundamentals, the market typically overreacts to it and values them extremely cheaply relative to their current earnings.
A systematic quantitative value factor investing strategy therefore buys those stocks at their cheapest point and holds them until the market becomes less pessimistic about their prospects and re-values their earnings. From Wikipedia, the free encyclopedia.
Journal of Investment Management. SSRN Review of Financial Studies. ISSN Your Complete Guide to Factor-based Investment. ISBN The Journal of Finance. CiteSeerX JSTOR Risk and Decision Analysis. S2CID Rochester, NY. Journal of Economic Theory. The Journal of Financial and Quantitative Analysis. Journal of Financial Economics.
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Factors represent certain security-specific attributes that explain the return and risk of a group of securities in the long run. Smart beta strategies explicitly target factor premiums and represent an alternative to traditional market capitalization-weighted indices beta. The term smart beta could, in theory, be used to describe any kind of factor-based strategy.
To sum up, factor investing emerged from the first empirical tests of the CAPM in equity markets, in the s, to become a widespread investment approach nowadays. Ang, W. Goetzmann and S. Report prepared for the Norwegian Ministry of Finance. Factor investing can be viewed as a third way of investing next to traditional fundamental active and passive strategies. This chapter shows:. In recent years, active managers have been criticized over how much value they add relative to the fees they charge.
Many investors have been turning towards passive strategies as a cheap way of gaining market exposure. The rise of passive has not been limited to US stocks. European and Asian equity markets experienced a similar uptrend, and passive has also been gaining traction in other asset classes. Yet passive strategies are far from perfect. They may appear to be cheap and prevent unpleasant surprises resulting from poor active calls.
However, they ultimately lead to chronic underperformance relative to the market, once costs are taken into account. But there are other concerns too. For example, due to their public transparency, passive strategies are prone to arbitrage. And their recent growth in popularity entails a risk of overcrowding. Also, because passive investing ignores decades of academic insights on factor premiums, replicating the market index implies investing a significant part of a portfolio in securities with negative expected returns.
Moreover, truly passive strategies cannot take sustainability considerations into account as they involve active investment choices. Meanwhile, the rise of computational power and the ability to store and process an ever-greater amount of data at low cost have profoundly changed the way financial markets operate. One of the most important transformations has been the emergence of quantitative investment strategies. The rise of quant has, in turn, enabled new breeds of rules-based active selection approaches to emerge.
Factor investing is one such example. The issues inherent in active and passive strategies have been instrumental in the rise of factor investing. In fact, factor investing is seen by many investors as a third way of investing. It has features that are similar to passive investing, such as its transparent, rules-based and low-cost nature.
But, like active investing, it aims to outperform the market. Factor investing is not designed to fully replace market cap-based passive investing, nor does it fully replace traditional active management. Many different types of investors, both institutional and retail, have actually embraced it as a third way of investing.
With this approach they aim to improve diversification and enhance returns without increasing costs. Why has factor investing become so popular over recent years? The reason is simple: it works in practice. Targeting proven factors in an efficient way is clearly worth the effort, even after the effects of management fees, taxes, trading costs and investment restrictions. Allocating to multiple factors thereby increases the probability of success. The factor investing label encompasses a wide variety of investment solutions that can be put to work in many different ways, using a broad array of investment vehicles.
I n short, factor investing offers a compelling alternative to traditional active and passive strategies. But, there are different approaches to factor investing, some more efficient than others. Factor investing is based on thorough academic research, with over four decades of empirical research showing it to be a robust investment concept. This chapter explains:.
Prior to the s, investors had very little understanding of the relationship between the risk and return of their investments. As soon as the early s, empirical tests showed that the link between risk and return is weaker than the CAPM theory suggests. One of the first studies, performed by Robert Haugen and James Heins, 9 showed that less volatile stocks had consistently outperformed more volatile ones over the period.
Fama, Kenneth French, In , another anomaly was observed, as Sanjoy Basu documented the value effect. In other words, stocks featuring a lower valuation tended to achieve higher returns than the CAPM would suggest. By the middle of the s, it was becoming clear that a number of factors other than market risk needed to be considered, and alternative models were developed. One of the most famous was the three-factor model developed in the early s by future Nobel prize laureate Eugene Fama and fellow researcher Kenneth French.
From that time, factor investing rapidly gained popularity among global investors, who were faced with similar issues and looked for ways to obtain a better-diversified portfolio at reasonable costs. In , for example, Mark Carhart proposed adding a momentum factor to the Fama-French model. The combination of the two is often referred to as the quality factor. Over the years, the number of academic studies showing that factor investing can also be applied to fixed income also rose dramatically, as large historical data sets on individual bonds became more widely available.
Nowadays, the research effort is going well beyond stocks and bonds: more and more analysis into the role of factors is being carried out in other asset classes. After this chapter, you should understand the scientific grounding of factor investing, and how the most influential factor models emerged.
You should also know that the research effort is ongoing. It was introduced in the early s by several academics independently: Jack Treynor , William F. Sharpe , John Lintner and Jan Mossin Haugen and J. Fama and K. Blitz and W. Over the years, dozens of purported factors have been identified by researchers.
In recent years, the combination of increased computing power, greater availability of data and rising interest among researchers has led to a dramatic rise in the number of purported factors reported in academic journals. Meanwhile, others only seem to work over short periods of time, or in a limited number of segments of the market. So what exactly is happening here? The problem is that when researchers analyze many different sets of data, looking for recurring patterns in returns, these patterns are likely to emerge purely by chance and still be statistically significant.
So, some caution is needed. Actually, it is possible to reduce the number of anomalies included in the zoo down to a handful of truly relevant factors. So how exactly should we choose which factors to invest in? To qualify as investable, a factor should meet a number of strict requirements:.
Implementable in practice and still outperform after the effects of trading costs and other market frictions. So, which factors actually work? Well, the list of factors each asset manager or index provider considers relevant can vary slightly depending on their own research and convictions. For example, some managers consider income — the tendency of high-income securities, for example high-dividend stocks, to outperform lower-income ones — as a standalone factor for equities.
Most providers stick to a handful of broadly accepted premiums. As an example, below is a brief overview of the different equity factors considered by some of the key players in the factor investing arena. Another consideration is that while the most common factors typically apply to all asset classes, some asset managers or index providers also have a slightly different list of relevant factors for each asset class.
In credits, for example, Robeco considers value, momentum, low risk and quality as a factor. The tendency of inexpensive securities, relative to their fundamentals, to outperform over the longer term. The tendency of securities that have performed well in the recent past to continue to perform well, and for securities that have performed poorly to continue to perform poorly.
Refers to the observation that low-risk securities tend to earn higher risk-adjusted returns than high-risk securities. The tendency of securities issued by sound and profitable companies to outperform those issued by less sound and profitable companies, and the market as a whole. The tendency of bonds issued by companies with little debt outstanding and small-capitalization stocks to outperform the market. In short, although dozens of market anomalies have been reported in the academic literature, investors should stick to a small number of factors that have been thoroughly tested in practice.
Harvey, Y. Liu and H. Hou, C. Xue and L. Factor investing can help pursue two main investment goals: reduce risk and enhance returns. But how does that work in practice? We saw in Chapter 2 that one of the most important transformations in the financial industry in recent years has been the massive shift from active to passive investment strategies, but that this raises a number of concerns.
For instance, although going down the passive route may be cheap and prevent unpleasant surprises from poor active calls, it leads ultimately to chronic underperformance once costs are taken into account. Passive strategies also expose investors to significant arbitrage risk for more details, see Chapter 7. Against this backdrop, many investors have turned to factor investing in a bid to achieve superior risk-adjusted returns while keeping costs relatively low.
Figure 6 and 7 show the historical performance of some of the most commonly accepted factors for equities and bonds. Performance figures for generic US value-weighted factor portfolios from July to December Quality is defined as the equal weighted combination of the Profitability and Investment factor portfolios. This chart is for illustrative purposes and does not represent the performance of any specific Robeco investment strategy. The value of your investments may fluctuate.
Results obtained in the past are no guarantee for the future. Source: Robeco, Bloomberg. USD investment grade January December Decile portfolios constructed using Robeco factor definitions. Credit returns measured over duration-matched government bonds. These graphs show that stocks featuring attractive value, momentum and quality factor characteristics achieve higher returns over the longer term. In the credit space this holds true for corporate bonds with attractive value, momentum and size factor characteristics.
Investors can either focus on each one of these factors independently or target a combination of factors for more stable outperformance over time. In recent years, risk reduction has become a top priority for many investors. Products exploiting the low-volatility or low-risk factors could be an ideal tool to help them do so without foregoing return potential.
Virtually unknown barely a decade ago, low-risk investing has in the ensuing years become a broadly accepted and adopted approach. The low volatility and low-risk factors are grounded in the empirical finding that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the longer term.
Academics have proposed several reasons to explain this anomaly and why it is likely to persist in the future. The most frequently discussed explanations relate to the rational behavior of asset managers, whose performance is generally evaluated against a benchmark. This is why asset managers tend to focus on being able to deliver outperformance and on minimizing relative risk. As a result, they tend to overlook low-risk stocks, which are characterized with market-like returns and high tracking error.
Other explanations include common behavioral biases of investors, such as overconfidence and the incentive structures, as well as investment constraints faced by many investors, in terms of leverage, benchmark, etc. These arguments are applicable for all proven factor premiums.
To summarize, different factor exposures can help achieve different investment goals. Depending on their needs and priorities, investors can either seek higher returns or reduce potential losses. Blitz and P. Factor investing can also help achieve very specific purposes, such as those most frequently cited in the latest annual survey of asset owners by FTSE Russell see Figure 8. This chapter will show you:.
But the dramatic increase in correlations between asset class returns during the market turmoil of the s began to cast doubt on the benefits of traditional diversification frameworks. The quest for more robust diversification techniques has seen many investors turn to factor investing — and with good reason. Many empirical studies have demonstrated the superior diversification benefits of factor investing, compared to classic diversification across sectors, regions and asset classes. For instance, a paper 19 by Antti Ilmanen and Jared Kizer analyzing data on several asset classes dating back to reported that diversification into and across factors has been much more effective in reducing portfolio volatility and market directionality than traditional asset class-based approaches.
Increased cost awareness among investors has also played a crucial role in the success of factor investing over the past few years. Factor investing is about capturing proven factor premiums in a rules-based way, in order to generate superior risk-adjusted returns after costs compared to the broader market.
The rules-based approach to generating superior performance is generally achieved at a lower cost, therefore charging lower fees, than traditional active managers. This is why factor investing is regarded by many investors as a third way in between passive and active, as we discussed in Chapter 2. It is transparent and has relatively low cost like passive, but an outperformance objective, like active.
Another frequently cited goal is to gain exposure to a specific factor. This may sound like stating the obvious, but it reminds us that, well before the advent of factor investing as a popular approach in the late s, many investors were already exploiting individual factor premiums.
Value strategies are a good example. For decades, prominent investors have advocated buying securities trading below their intrinsic value and many active managers have been offering so-called value strategies. The quest for higher and more stable returns has convinced many investors to turn to strategies featuring high-income characteristics. In recent years, as bond yields fell across the developed world, these strategies have been gaining considerable traction, in particular among those asset owners interested in factor investing.
Income-related variables indeed represent a key input in the definition of some of the most commonly-admitted factors. Carry is an obvious case in point. But this also holds true for other proven factors, such as value or quality. That is why, in equity markets, value and low-risk investing typically involve selecting stocks from firms with high and stable dividends. The implementation of factor investing is also a good opportunity to consider environmental, social and governance ESG aspects.
Growing demand for sustainable investment solutions means asset managers are increasingly expected to take ESG criteria into account in their investment processes, without sacrificing returns. Factor-based strategies are particularly suitable for smart sustainability integration. Their rules-based nature makes it relatively easy to integrate additional quantifiable variables in the security selection and portfolio construction process.
From this perspective, a factor-based approach that integrates sustainability aspects in the investment methodology is not very different from a standard factor-based approach, where securities are included in a portfolio solely based on their factor characteristics. For more information about Sustainable Investing, please visit our dedicated Essentials learning module. In short, on top of enhancing returns and reducing risk, factor investing can also be used to improve diversification, reduce costs, gain strategic exposure to a specific factor and generate income.
Ilmanen and J. Not all products, labelled as factor strategies lead to the best investment outcomes. In particular, generic products can prove disappointing over time. Investors can choose from hundreds of factor-based products, from basic single-factor equity ETFs to sophisticated multi-factor multi-asset solutions. However, different factor strategies usually lead to different investment outcomes. Indeed, there is very wide dispersion in the performance of mutual funds exploiting equity factor strategies.
Factor strategies need to be well designed and smartly implemented. Key challenges range from determining the right factor strategy — or set of strategies — for each investor, to ensuring that the portfolio is properly constructed. Finding the right balance between rebalancing the portfolio to maintain exposure to the relevant factors and keeping turnover and transaction costs low is also important.
Generic factor strategies typically fail to address these challenges. For instance, many generic products provide only limited exposure to a targeted factor, or combination of factors, as well as unwanted negative exposures to other proven factors. The reason is that individual factors can have negative exposures to other proven factors, and generic factor definitions tend to overlook this issue.
An example would be a low-volatility stock that is expensive so it provides negative exposure to the value factor , or a quality stock that is in a downward trend negative exposure to momentum. Another major flaw of products that track public smart beta indices is that they are prone to overcrowding and arbitrage. Generic factor indices often publicly share their holdings and rebalancing methodology. This transparency comes at a cost for those who track these indices, as other market participants can identify in advance which trades are going to be executed and opportunistically take advantage of these moves.
As a result, passive investors tend to buy securities at inflated prices and to sell them at depressed prices. Efficient factor strategies, by contrast, are designed in such a way that factor premiums do not clash with each other. One way of achieving this is to apply enhanced factor definitions that ensure the securities providing positive exposure to one factor do not involve negative exposure to others. For example, it is possible to avoid overpriced low-risk stocks by also considering valuation criteria in the selection process.
Efficient factor strategies also use portfolio-construction processes designed to mitigate turnover and keep trading costs under control. The corporate bond market provides good examples of this. A company typically issues only one or two types of stocks common and preferred , but far more types of bonds. Bonds of the same issuer can differ in the maturity date, issue size, currency, and subordination. These characteristics require careful treatment, especially in defining the factors and designing the investment process.
Not all bonds from the same issuer are necessarily equally attractive: some might be cheap, others expensive. Another example is the liquidity issues that arise in the corporate bond market. Unlike equity markets, bonds differ substantially in terms of their liquidity. Some bonds trade every day, but others trade only infrequently. As a result, transaction costs can differ greatly from one issue to another. Being able to tackle these kinds of asset-specific implementation challenges in the most efficient way can have a significant impact on performance.
But it typically requires a sophisticated approach. Investors should consider this as a key differentiator between efficient and not-so-efficient factor investing solutions. To conclude, most generic products expose investors to serious pitfalls, including chronic underperformance after costs and arbitrage risk. Enhanced factor strategies provide an answer.
Over the past decade, the financial industry has seen a structural shift as investors allocated funds from actively managed fundamental strategies to passive vehicles and factor investing strategies. How can investors benefit from factor premiums? Predominantly institutional investors kicked off the rise of factor investing in the s, as they acknowledged the academic evidence for the existence of factor premiums.
Large financial institutions followed suit. The case of a large European private bank illustrates how factor investing has been embraced globally. The bank had struggled with disappointing returns after the financial crisis and looked for products that offered better diversification. At the same time, they were looking to keep their average fee level relatively low.
Allocating more to passive solutions was not desired as this would have a negative impact on return expectations. On the other hand, allocating more to active fundamental strategies would not match with their relatively low average fee objective. Therefore, they started looking for other sources of return and started evaluating different factor managers. In the early s, they jointly developed a multi-factor strategy with two global asset managers to be offered to their clients via their fund platform.
As a response to the increased awareness for and interest in factor investing, asset managers and index providers have been very active in launching factor-based products across different asset classes. Today, the industry offers a variety of ways to implement the proven principles of factor investing.
These range from public smart beta indices to proprietary active multi-factor multi-asset solutions. With such a wide range of options available, how should investors go about choosing a factor strategy to invest in? To answer this question, they could start by answering a few pivotal questions:. Factor investing works in practice and many investors embrace it. There are many ways to implement factors in a portfolio, and numerous products are available in the market that can deliver the desired results.
Below are 15 multiple-choice questions on the 8 chapters you have completed. Click on the box that you think contains the correct answer. If you answer 12 or more questions correctly, you will be awarded 2 hours of CPD. Your feedback. Good luck! What is factor investing? In this chapter, you will learn: The basic principles behind factor investing When its foundations were laid That factor investing has rapidly gained popularity among investors Factor investing Factor investing is about investing in securities featuring certain characteristics that have proved to deliver higher risk-adjusted returns than the market over time, following a fixed set of rules.
Factor premiums Factor premiums have been extensively documented in academic literature for over four decades. Factor investing today Systematic In the ensuing years, prominent institutional investors have publicly embraced more systematic approaches to portfolio allocation and security selection based on these insights. Smart beta, quant and factor-based strategies Estimates of the amount of money invested in factor strategies vary from one source to another, ranging from USD 1 to 2 trillion globally in most cases.
Figure 1: Smart beta adoption percentage by region. Table 1: Three key concepts The definitions of concepts such as quantitative investing, factor investing, or smart beta are far from set in stone. The earliest and most well-known factor is value, which can be defined primarily as change in the market valuation of earnings per share "multiple expansion" , measured as the PE ratio.
The opportunity to capitalize on the value factor arises from the fact that when stocks suffer weakness in their fundamentals, the market typically overreacts to it and values them extremely cheaply relative to their current earnings. A systematic quantitative value factor investing strategy therefore buys those stocks at their cheapest point and holds them until the market becomes less pessimistic about their prospects and re-values their earnings.
From Wikipedia, the free encyclopedia. Journal of Investment Management. SSRN Review of Financial Studies. ISSN Your Complete Guide to Factor-based Investment. ISBN The Journal of Finance. CiteSeerX JSTOR Risk and Decision Analysis. S2CID Rochester, NY. Journal of Economic Theory.
The Journal of Financial and Quantitative Analysis. Journal of Financial Economics. ISSN X. The Journal of Alternative Investments.