Factor investing is one of the most popular investment strategies among institutional and retail investors alike. It involves selecting and managing securities based on specific factors or characteristics that are believed to influence their risk and return profiles. Instead of focusing solely on asset classes like stocks or bonds, factor investing emphasizes underlying attributes or factors that historically contribute to the performance of a group of securities.
Factor Investing: Research Origin
“It all started with a paper from Fama and French in 1992,” says Marco Santanche, a quant strategist and author of the newsletter Quant Evolution. “They tried to explain the outperformance of some groups of stocks compared with others using empirical, measurable factors that could be observed on the market.”
The Capital Asset Pricing Model (CAPM), the most widespread model at the time and still an important one in finance, explains the returns of stocks by using just one factor: the market risk, or Beta, β. Although extremely important, this factor is not able to explain the observable differences between groups of stocks. Fama and French came up with a solution to this problem, by adding (initially) two factors: small caps and high-value stocks.
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“The three factors, which we will call β, SMB (small-minus-big) and HML (high-minus-low value), can be considered a fundamental change in the financial world,” notes Santanche in his newsletter. “They represent a performance anomaly that suggests that we could actually subset a universe of companies into multiple, smaller groups by defining a clear metric (for value, for example, it was the book-to-market ratio; for small-minus-big, it was their market capitalization) and we would be able to collect a premium which is independent from the market as a whole.”
This has always been an extremely desirable property for investments; however, it must be noted that factors do have cycles and regimes, and over time they clearly show how some of them might outperform in bullish markets, bearish markets, inflationary environments, etc.
How Can I Invest in Factors?
Many ETF providers offer factor-based strategies that actively select stocks (and this has been expanding to additional asset classes as well). As noted by Santanche, “The advantage of this approach is that the selected group has an empirical exposure to a factor that should, in theory, outperform in the long term the rest of the universe (say: high-value stocks would underperform low-value ones).”
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To invest in one specific factor investors can buy, for example, some of the most liquid ETFs from the main providers.
Factor Investing: Factors to Consider
While researchers have identified over 300 factors, the 5 most popular and crucial factors are value, momentum, low volatility, quality, and dividend. Investors will be able to find ETFs based on these 5 factors from all major ETF providers.
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Value. As one of the original factors, value is very well known and studied. It refers to buying undervalued stocks and selling overvalued stocks based on some metric. The Fama-French definition of value was based on the book-to-market ratio, an indicator of companies' financial health. However, modern methodologies might consider a variety of metrics to identify the value of the underlying stocks.
Momentum. Another important, well known and studied factor is momentum. The rationale is to buy outperforming stocks and sell underperforming ones, as investors tend to select securities based on their past performance.
Low volatility. This factor assumes that the performance of stocks with low volatility is superior to their riskier counterparts over the long term.
Quality. This expresses the tendency of high-quality stocks with typically more stable earnings, stronger balance sheets and higher margins to outperform low-quality stocks, over a long time horizon.
Dividend. This factor can be defined as the outperformance of those stocks paying high dividends compared with peers with lower dividends.
It is important to note that within the same category of factor and factor-based ETF, differences still exist in the composition and selection methodologies employed by different ETF providers.
“One could potentially subset the universe of stocks in many ways,” as noted by Santanche in his newsletter. “In many cases, such as Quality, the methodology applied by different ETF providers could be extremely different. In other cases, like the Size factor, there isn’t a material difference. The performance of these factors for different providers might vary due to practical differences in implementation, such as rebalancing periods, additional filters applied to the universe (for example, liquidity), etc.”
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
