Invesco Global Systematic Investing Study 2023

Factor investing is a systematic, evidence-based investment approach that targets certain characteristics of an asset, called factors, which tell us something useful about the security’s expected return or risk. It is an investment process based on evidence and empirical research in which every asset return, and hence every portfolio, can be broken down into a set of factors that drive risk and returns. We can specifically structure a portfolio around investment factors. Some of the most common investment factors are value, momentum, quality and low volatility. By investing in assets and portfolios with attractive factor characteristics, investors can aim to earn a premium over the long-term. Factor Investing is the result of profound academic research, starting with the first one-factor model developed in the 1960s.

The idea behind factor investing is to systematically exploit the drivers of risk and return and thereby to generate portfolios that deliver a better risk-return profile. Factor investing can be seen as a third distinct approach alongside market weighted indexing and traditional active. Depending on the application and complexity of the approaches, it usually lies somewhere between the other two options in both expected value-add and cost. It also has key advantages like transparency, scalability, and cost when compared to traditional active approaches, while not giving up the ability to customize, control risk and pursue higher returns as with market cap weighted investing.

Some of the common factors targeted are the following:

Value: cheaply valued stocks are expected to produce higher returns. The simple rationale for the value factor is that it makes sense to expect that buying an asset which is cheaply valued will produce higher subsequent returns than buying when it is expensively valued. The greater return potential of ‘value’ versus its opposite of ‘growth’ was identified by Basu in 1977 and has been widely researched and measured since then.

Momentum: stocks that have performed strongly in the past are expected to continue doing so. The momentum factor describes the phenomenon that stocks that have performed well in the past have tended to continue to do so – at least over the near term. It was first identified in 1993 by Jegadeesh and Titman who found that buying past winners and selling past losers was a strategy that produced excess returns.

Quality: better quality companies expect to produce better returns than lower quality companies. Factor-based strategies address quality by selecting holdings according to balance sheet measures of quality, such as return on equity and financial leverage.

Volatility: low volatility stocks expect to outperform high volatility stocks on a risk-adjusted basis. The rationale for why stocks with historically low volatility may produce higher risk-adjusted returns is that they are typically stable, more defensive companies. Although they may have more limited growth prospects, they tend to have stronger balance sheets, typically pay dividends and can grow earnings and dividends even in a lower economic growth environment. The low volatility factor was first identified in the early 1970s by Haugen and Heins.

The reasons for the existence of factor returns may differ among academics and practitioners but they all have one thing in common: Rationales for investment factors come in one of three forms; risk premia, behavioural anomalies and market structure:

Risk premia: the factor compensates for carrying systematic risk.

Behavioural anomalies: the factor is rooted in persistent, but not necessarily rational investor behaviour.

Market structure: the factor premium potentially results from the structure of the industry, market constraints, or similar.

It can be difficult to establish a definitive link between factor performance and behavioural phenomena, and there is a temptation to use this as a catch-all rationalisation where evidence of risk premia or structural influences have not been demonstrated. Even when investor behaviour does appear, on the surface, to be irrational - this may reflect some other unobserved but rational motivation for the behaviour. For this reason, it cannot be assumed that the market will overcome apparent behavioural anomalies by investors learning to trade more rationally. 

While factor investing is well established in equities, the rationale behind factor investing is not asset class-specific and is equally powerful when applied to fixed income portfolios. It has been seen that there are factors like value, carry and low volatility that can explain the drivers of risk and return of fixed income portfolios.