Diversification has been a long preached methodology amongst value investors who wish to reduce risk in their investment portfolio. However, there are alternative investment methodologies like factor investing that can help investors improve their diversification strategy to enhance their returns. Let’s take a look at how factor investing works and how you can use it to your advantage.
Summary
- Factor investing is a strategy that focuses on finding and investing in securities that have higher returns while keeping a stable level of diversification and risk
- The two main investing factors include macroeconomic and style factors
- The main foundations of factor investing include financial quality, value, size, momentum, carry, and volatility level
What is Factor Investing?
Factor investing is a diverse investing methodology that is designed to improve overall portfolio diversification, with the goal of generating higher market returns. Diversification is considered by many investors as a safety beacon when it comes to capital preservation and long-term growth. However, your capital can be at risk of loss if you over-diversify when you shouldn’t. This is where factor investing comes into play and happens to share similarities to the GARP style of investing.
Investing in different factors as the market shifts in a new direction can help rebalance your portfolio and adjust it as the market changes. It’s a more conscious style of investing that is meant to enhance your returns as the market changes.
The main premise behind factor investing is to choose securities and asset classes that have higher returns while keeping diversification and risk well balanced. By definition, most hedge funds operate in this way and seek to target returns and investments that are uncorrelated to the wider market.
However, just because factor investing sounds ideal in theory, it’s not always as straightforward to implement. Investors have to not only be able to observe shifts in economic fundamental factors, but they also have to be willing to go against the herd mentality and take advantage of investment opportunities most traditional investors would write off.
Different Types of Factors
The two main types of factors that drive returns in stocks, mutual funds, bonds, or commodities are macroeconomic factors and style factors.
Macroeconomic Factors
The most common macroeconomic factors on a wider economic scale include:
- Inflation rate
- GDP growth
- Unemployment rate
- Credit rating
- Interest Rates
- Liquidity
- Emerging Markets
There are also macroeconomic factors that are more specific to a company’s performance such as:
- Credit rating of the company
- Stock liquidity
- Stock price volatility
- Number of outstanding shares
- Interest rates
In addition to macroeconomic factors, there are style factors.
Style Factors
These are variances in investing factors picked out by investors that impact how investable a security or asset class is. Style factors help to push different levels of returns based on how risk tolerance and investment selection. Style factors include:
- Financial quality
- Value
- Size
- Momentum
- Volatility/Risk
These are also commonly referred to as the foundations of factor investing. They can serve as a basis for helping you select investment vehicles that can outperform the broader market.
The 5 Foundations of Factor Investing
Investors will always have some sort of macroeconomic factor to consider when selecting and diversifying their investments. However, the basis for factor investing involves being able to discern and find investments that are poised to produce high returns during periods of low economic growth. As such, it’s important to become intimately familiar with the six foundations of factor investing.
Financial Quality
Financial quality represents the level of financial stability and consistency of a company. There are many ways to evaluate the financial quality and stability of a company. However, the most common is by ensuring a company has stable earnings and comparing its return on equity relative to other competitors in that sector. This is the starting foundation for factor investing.
Value
Value seeks to find investments that can produce excess returns from stocks that have a low price relative to their true fundamental factors. A common way to find and evaluate a valuable investment is by analyzing financial performance factors such as free cash flow, price to earnings, price to book, and dividends.
Size
The size of the company you invest in will impact your returns. Generally, portfolios containing small-cap stocks tend to have larger returns than portfolios that are filled mainly with large-cap stocks and bonds. Small-cap stocks tend to carry higher levels of risk, however, their returns tend to be much greater if your timing is on point.
Momentum
Momentum is a key component of factor investing. It represents the level at which a stock has outperformed other investments in the past. You want to focus on finding stocks that have had a strong growth momentum in the past three to five years.
Volatility/Risk
The volatility and risk represent the risk appetite and tolerance for the investment. This is typically measured by the stock’s beta. The beta is a measure of a stock’s volatility in relation to the general market. Equities with a beta of 1, have volatility swings that are identical to the general market. In order to generate returns above the market, you must focus on findings stocks that have a beta over 1.
Risks Associated With Factor Investing
To reiterate, factor investing focuses on finding investments that satisfy the three criteria below:
- Outperformance
- Reduced volatility
- Diversification
However, each one of these criteria comes with its own set of risks. In order to outperform other investments, you have to take risks that are uncorrelated to the general market. Seeking outperformance creates additional risk. In addition, finding investments with reduced volatility levels to outperform traditional returns can be difficult. Lastly, finding a strategy and investment that also diversifies your investments in a balanced way can be challenging, but very rewarding.
Factor Investing ETFs
If you’re interested in factor investing Blackrock has a list of ETFs that are structured specifically for this style of investing. They have ETFs that focus on four separate factor strategies including:
- Single Factor
- Multifactor
- Minimum Volatility
- Fixed Income
