- By Mark Marex, Product Development Specialist, Nasdaq Global Information Services
Factors in the investment world may sound difficult to grasp at first, but are ultimately akin to what we would consider “drivers of success” in other competitive realms such as sports (fantasy or real-life) or data-rich sectors like real estate, consumer retail, and medicine. Factors are, in other words, the building blocks of investment returns. They usually have clearly defined calculation methodologies (in some cases, more than one for a given factor) that support their existence across academia and in the everyday world of modern finance. An investor can utilize factors to both deconstruct the returns of a given investment, as well as to construct an optimal portfolio according to her preferences, including but not limited to individual risk tolerance, market forecasts, return goals, and diversification needs.
In professional team sports – especially baseball, basketball, and football – coaches and their staff (along with their fantasy counterparts) now use advanced statistical methods to determine the optimal composition of their teams. Moneyball, written by Michael Lewis, kicked off the trend in baseball, which has spread to other sports. Players at different positions can be analyzed based on their historical performance (“stats”) as well as how they impact the performance of others. Optimal selection is constrained by salary caps, number of skilled players at any one position (e.g. lefty pitchers), etc.
In Finance, we can think of the universe of available stocks to invest in as akin to the universe of players in a sport:
- US vs. International; Developed Markets vs. Emerging Markets
- Large-cap firms (Google, AT&T, Bank of America) vs. mid/small/micro-cap (firms you’ve likely never heard of)
- Firms whose stocks provide more dividend income vs. capital appreciation upside (vs. the distinguished few that provide both)
- Firms that are otherwise more or less “risky” than others to invest in (based on their industry, management, financial condition, etc.)
Some factors have been academically studied for decades and supported by volumes of research, while others are more recently discovered by investors and may have more “real-world” support than theoretical support. Just like in sports, selecting what seems like the “right” investment based on one or more factors in a given year carries risk to it: risk of injury (unforeseen negative development that cannot be controlled), risk of misrepresentation, risk of gradual decline due to age, and/or risk of market evolution. Even the factors with the most empirical research behind them may not perform well for anywhere from a year to 10+ years, which is a function of not only the stock market’s high level of complexity, but also that of the global economy.
Factors are, broadly speaking, any observable relationship between companies, their securities (stocks, bonds, etc.), or the broader market and economy that exerts upward (or downward) pressure on the price of said securities, both historically-speaking and forward-looking.
Some factors relate to characteristics of the firms themselves:
- Size (how much a company is worth)
- Quality / Profitability (how efficiently a firm is managed)
- Growth (how quickly a firm is expanding)
Other factors relate more towards the specific characteristics of the securities:
- Dividend / Yield (how much income a firm’s stock provides to the investor)
- Momentum (how strongly a firm’s stock price has been moving upward or downward)
- Liquidity (how frequently the firm’s stock trades, and how easy it is to trade a large amount of it)
Still other factors describe the relationship between a firm’s stock and the rest of the stock market:
- Value (how cheaply a firm’s stock is priced relative to other stocks in the market)
- Volatility (how sharply a firm’s stock price moves in a given day relative to other stocks in the market)
- Beta (how closely a firm’s stock price tracks the movement in the broader market)
Overall, investors have established that the higher a stock’s “risk,” the higher the return an investor in that stock should expect. Historically, this has been observed with Size (smaller firms are riskier and produce higher returns); Value (cheaper firms are riskier and produce higher returns); and Beta (firms that move more closely with the market attract and absorb “market risk” in addition to their individual, unique risks). However, all of these have the potential to outperform or underperform the broader market for years at a time.
To read the full report, click here.