Factor Investing: What It Is and How It Works

To outsiders and those new to investing, one of the biggest barriers to the financial world is that it often seems like it has its own language. If you tune into CNBC, Bloomberg or Fox Business for the first time, you will probably hear trading and investment professionals using words and phrases, usually without explanations. In many ways, this is not an accident. It gives the impression that the person speaking is smart while also making their profession seem incredibly difficult, thereby justifying huge salaries and massive bonuses.

Frequently though, the words and phrases they use describe concepts that are actually quite simple. Factor investing is an example of that.

What Is Factor Investing?

This refers to an investing style where one or more “factors” are considered before buying. Your investments are made based on those considerations to beat the average return of a market, the so-called benchmark return.

It is what is known as a “quantitative” style of investing, meaning that decisions are based on data and history rather than opinions. Put simply, it means you do some research before you buy.

The phrase is usually used in the context of stocks, but it can be applied to any traded market. Bonds, gold, oil and currencies can all be evaluated based on one or a combination of multiple factors, some of which are unique to their markets.

Factors that apply to markets in general, such as the state of and prospects for the global or national economy, are called “macro” factors, whereas those that apply to only a specific bond, commodity, currency or stock are called “micro” factors.   

What Main Factors Are Used in Factor Investing?

On the macro side, investors consider factors like economic data, the jobs report, inflation figures, and how fast the economy is growing or shrinking, measured by changes to the GDP.

Micro factors include price, the size of a company, a stock’s volatility (how much its price usually response to changing conditions and news), and the quality of the company, defined by things like how much debt it has, what cash flow it generates, and how it has handled adversity in the past.

What sets factor investing apart is that only those factors matter. Opinions of whether something is a good investment or not is informed only by those measurable factors, not what you or others might think of a company’s prospects or reputation, and certainly not by your emotions.

Macro Versus Micro Factors

The first thing to understand is that macro and micro factors have different roles in your decision making. Macro factors are usually used to decide when to buy, and micro factors help you decide what to buy. If you are investing a dollar amount or percentage of your income on a regular basis, macro factors are much less influential from a timing perspective. The point of investing that way, known as dollar cost averaging in investment jargon, is to minimize timing risk by sticking to a preset schedule, thus reducing the impact of news, emotion and outside opinion.

However, that doesn’t mean that macro factors can be ignored completely. Things like the state of the economy can influence the relative performance of different sectors of the market and individual industries. When the going is good, luxury goods do better, as do somewhat speculative bets on companies in growing industries and high volatility stocks. Conversely, when times get tough, steadier, less volatile investments in things like consumer staples, energy and defense will outperform the average.

Value versus Momentum

Those factors can influence your decisions, but most of the time, what you buy if you are adopting a factor investing style will be dictated by micro factors. The most obvious of those is price, but there are multiple factors to consider even within that. The most common are value and momentum.

The value of a stock refers to its price relative to its past and expected profits. If, say, XYZ typically trades at around 20x its earnings but is available at 15x, it is value at the current price. There are probably short-term factors that have dragged the price down, but it can reasonably be expected to return to the mean at some point.

Momentum stocks, on the other hand, are those that have performed well recently, regardless of whether or not they represent value. Generally, momentum stocks are better short-term plays, while value is a better option for longer-term investments. The ideal, of course, is when a stock fits in both categories!

Size

Another popular factor for investors is the size of the company. We tend to be drawn to larger companies, because they are better known and “safer” given that they have better resources to ride out tough times. They generally do better when the outlook is uncertain and/or when the market is falling, but research has shown that, over time, small companies, those with a market capitalization of under $2 billion, offer better returns.

Implementing Factor Investing

Whether you choose to use any or all of the above factors or incorporate some others that you see as important, the good news is that factor investing is easier now to do than ever before. If you want to make your own picks, the information and data you need is usually available with just a quick internet search. If you would rather not do the work, though, there are exchange traded funds (ETFs) available that reflect different factors; large and small cap ETFs for size, value and growth funds for style, and pretty much anything else you can think of. Shares in ETFs are bought and sold on exchanges, just like stocks, and have low or no entry and exit costs.

The simplest way to invest is just to buy a fund that tracks the broad market, such as SPDR S&P 500 (SPY) that tracks the S&P 500, or Invesco QQQ Trust, Series 1 (QQQ) that follows the Nasdaq, or SPDR Dow Jones Industrial Average ETF (DIA) for the Dow. These will give you just below the returns of those indices after fees. However, if you want to take a more active role in managing your investments and can see that different factors benefit different stocks at different times, factor investing is the way to approach that. It involves a bit more work and effort but can pay off handsomely over time.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

Other Topics

Investing Markets Economy