Insight: What is factor investing?
Factor investing identifies characteristics of securities that can be targeted with investable securities and structuring portfolios to either capture or avoid specific factors in a systematic way. A common objective of factor investing within a rulesbased framework is to position the portfolio in an attempt to outperform the market. In addition, factor-based investing can contribute to portfolio diversification or as a risk control mechanism. Finally, factor strategies are used as a cost efficient way to lower overall portfolio costs. Due to the explanatory power of investment factors, factor investing is becoming a strategic, long-term element of many asset allocations. However, it can also be used in a tactical way. Factor investing is currently receiving much attention, but the approach as such isn’t new — its roots can be traced as far back as the 1930s. In the equity area, the most well-known style factors include value, size, momentum, volatility and quality.
The term “factor” is sometimes used to refer to just about any piece of data, but when Invesco talks about factor investing we mean something specific. An investment factor is one we can pursue in a live portfolio based on directly observable characteristics of securities with large scale of assets, to achieve an investment outcome. An investment factor should have a theoretical rationale and empirical support, that is scalable and expressible using tradeable securities. Investment factors should be persistent, pervasive, robust and distinct.
Value, size and volatility
With value strategies, the emphasis is placed on securities that are priced at a discount to other similar securities. The underlying assumption is that, over the long term, purchasing securities at lower prices will lead to higher returns. But how do you determine value? As it turns out, there are many different approaches that yield similar results. The index provider MSCI, for example, uses dividend yield, price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio) as criteria. Cash flows and net profit are sometimes used as criteria as well. Price-to-book — as well as size — was used in 1992 by the scholars Eugene Fama and Kenneth French to expand the capital asset pricing model to produce the Fama-French three-factor model1. In the fixed income context, value strategies can measure yield relative to credit rating by industry. However, there are also points of criticism. Quite apart from the fact that value strategies aren’t successful in all market phases, there is the considerable concern that innovative companies that don’t pay dividends and have a high price-to-book value are excluded. For this reason, Invesco often prefers cash flow yield as a measure of value in equities.
With size (i. e. small cap) strategies, the focus is on the shares of small companies in the expectation that they will outperform those of large companies. This relationship was first demonstrated in a study by Rolf W. Banz in 19812. Subsequent studies confirmed these results. There are several explanations for the size factor. On the one hand, it is claimed that small companies have better growth prospects than large established companies. On the other hand, analysts focus less on these companies, which therefore tend to be overlooked. It is also said that the shares of small companies are not as liquid as those of their larger counterparts, with investors preferring the shares of large companies. In some markets, the consistency and magnitude of the size factor is tenuous, but it is often observed that other investment factors seem to work quite well across smaller companies, which increases its usefulness.
The volatility factor (also known as minimum volatility or minimum variance) implies that shares associated with lower volatility perform better on a risk-adjusted basis than those with higher volatility. The observation was first described in 1972 by Robert Haugen and A. James Heins3. Later studies also found that low-volatility shares outperformed those with high volatility over the long term on a risk-adjusted basis. What might be the rationale to explain this unexpected phenomenon? One possibility is a difference between reality and the realm of academic research. Given a set of assumptions, theory says investors should be indifferent between low and high volatility stocks because of access to leverage. In reality, investors may not be able to access leverage, or the costs of leverage might be higher than assumed in the research. This practical reality could cause investors to be willing to accept less incremental return as volatility increases. On the other hand, the approach is criticized for its poor sector coverage, with low volatility healthcare stocks overrepresented, for example. One note about the low-volatility factor: The most rigorous studies of this phenomenon find results are largely driven by poor returns of highly volatile securities. This result has important implications when considering a low-volatility investment, but details of this finding are beyond the scope of this introduction.
Insight: Equity style factors
Value, size, volatility, quality, and momentum are among the most established factor strategies in equity investing. The objective of the value strategy is to identify securities that are priced at a discount by some measure. Size strategies focus on the shares of small companies, while low-volatility strategies emphasize securities whose prices fluctuate less than those of other securities. Momentum strategies involve the purchase of equities that have recently recorded an above-average performance, while quality strategies search for companies of superior quality. The distinction is made on the basis of quantifiable metrics such as a price-to-earnings and price-tobook ratio, dividend yield or volatility. While some criteria are generally recognized, the approaches can vary in other aspects. In all cases, however, it is a systematic, rulesbased process.
Momentum and quality
Within the framework of momentum strategies, the most known factor is price momentum. Securities are purchased if they have performed well recently, and sold if they have performed badly. The outperformers of the recent past are therefore seen as the outperformers of the future4. This factor was “discovered” by Jegadeesh and Titman in 19935. Momentum strategies are usually justified by the findings of behavioral finance, which focuses on known modes of behavior, such as the herd mentality, or anchoring bias for example. More recent studies find that earnings momentum largely subsumes price momentum. Earnings momentum is commonly defined as the trend in earnings surprises or changes in earnings expectations. The rationale for earnings momentum is similar to price momentum, although the finding impacts how the factor is captured in portfolios. Recent research suggests that the momentum factor also persists for bonds, measured by return over a recent period of time.
The quality factor entails a focus on the shares of high-quality companies because they tend to outperform those of lesser quality. Robert Noxy-Marx demonstrated in 20126 that the shares of highly profitable companies achieve better risk-adjusted performance than less profitable companies. Other criteria that are used to define quality include cash flows and debt ratios, as well as the quality of the management and business model, along with the market environment, and, with fixed income, a high credit rating, low duration, and low historical volatility. However, it is problematic that some elements of quality often can’t be measured, such as the value of a brand or good reputation. Not least, there is the danger that young high-growth companies — which don’t yet have steady earnings — are excluded, as are companies that are highly sensitive to economic trends.