Factor Investing
What Is Factor Investing?
Factor investing is a strategy that picks securities on credits that are associated with higher returns. There are two principal types of factors that have driven returns of stocks, bonds, and different factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the last option plans to make sense of returns and risks inside asset classes.
A few common macroeconomic factors include: the rate of expansion; GDP growth; and the unemployment rate. Microeconomic factors include: an organization's credit; its share liquidity; and stock price volatility. Style factors include growth versus value stocks; market capitalization; and industry sector.
Understanding Factor Investing
Factor investing, from a hypothetical stance, is intended to upgrade diversification, generate above-market returns and oversee risk. Portfolio diversification has long been a well known safety strategy, yet the gains of diversification are lost in the event that the picked securities move in lockstep with the broader market. For instance, an investor might pick a combination of stocks and bonds that all decline in value when certain market conditions emerge. The uplifting news is factor investing can offset possible risks by focusing on broad, determined, and long recognized drivers of returns.
Since traditional portfolio allocations, as 60% stocks and 40% bonds, are relatively simple to execute, factor investing can appear to be overpowering given the number of factors to browse. As opposed to see complex credits, for example, momentum, fledglings to factor investing can zero in on less difficult components, like style (growth versus value), size (large cap versus small cap), and risk (beta). These traits are promptly accessible for most securities and are listed on well known stock research sites.
Groundworks of Factor Investing
Value
Value expects to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly followed by price to book, price to earnings, dividends, and free cash flow.
Size
Historically, portfolios comprising of small-cap stocks show greater returns than portfolios with just large-cap stocks. Investors can capture size by checking out at the market capitalization of a stock.
Momentum
Stocks that have beated in the past will more often than not display strong returns going ahead. A momentum strategy is grounded in relative returns from three months to a one-year time span.
Quality
Quality is defined by low debt, stable earnings, predictable asset growth, and strong corporate governance. Investors can distinguish quality stocks by utilizing common financial metrics like a return to equity, debt to equity and earnings variability.
Volatility
Experimental research recommends that stocks with low volatility earn greater risk-adjusted returns than highly unpredictable assets. Measuring standard deviation from a one-to three-year time span is a common method of capturing beta.
Model: The Fama-French 3-Factor Model
One widely utilized multi-factor model is the Fama and French three-factor model that develops the capital asset pricing model (CAPM). Worked by financial experts Eugene Fama and Kenneth French, the Fama and French model uses three factors: size of firms, book-to-market values, and excess return on the market. In the model's phrasing, the three factors utilized are SMB (small minus big), HML (high minus low) and the portfolio's return less the risk free rate of return. SMB accounts for public corporations with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.
Highlights
- Smart beta is a common application of a factor investing strategy.
- Factor investing uses multiple factors, including macroeconomic as well as fundamental and statistical, are utilized to dissect and make sense of asset prices and build an investment strategy.
- Factors that have been distinguished by investors include: growth versus value; market capitalization; credit rating; and stock price volatility - among several others.
