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What are factors in simple terms
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STRATxAI

February 2024 · 5 min read

Factor investing explained

Research

When equity literature refers to factors and investing, they are really referring to style factors. Factor investing is a rules-based approach that consists of grouping stocks where each of the stocks share common financial properties. These properties can be

  • related by common fundamental balance sheet items
  • based on historical performance
  • statistical properties of stock returns

Factors are a means of grouping together stocks into portfolios where, it has been shown through history that, investing in these portfolios would have given investors a source of consistent risk-adjusted returns.

Factors have risen to prominence since the early 2000s and especially since 2010 and the rise of some smart beta type factor exposure. Factor investing has been growing at a 30% year-on-year growth rate since 2010, with large asset managers like Blackrock indicating that factor investing will be worth over US$3 trillion by 2023.

Why should investors use factors

Factors have been shown to produce higher risk-adjusted returns than the overall market - this has been shown using historical data and a huge amount of academic studies.

What are factors ?

Factors are a collection of specific rules that group specific stocks together based on similar characteristics. Factors, if applied for the long term, can be used to capture the factor premium that has been shown to exist in the financial markets.

If the efficient market hypothesis was to be believed, then stocks prices would contain all current information and be fairly price and factor premiums would not exist. However, due to behavioural biases and some investment and benchmarking criteria stock returns have been shown to exhibit these factor premiums. If investors invest in factors for the long-term, then these factors can be harvested for superior returns.

What criteria ensure a factor exists ?

  • it must follow a rules-based approach, based on financial metrics or price returns
  • it makes economic sense and most likely has academic backing
  • it has shown itself to be robust through long periods of time
  • ideally it works in most, if not all, geographies of the world

Each investment provider will construct their factors slightly differently. The rules governing the construction of factors are mostly heuristic in nature and will result in quantitative and financial modelling decisions that each provider makes for themselves. Overall the factors will still represent the same concept but the backtested results may differ slightly amongst the providers.

The top 5 factors

The factors found to be consistently referenced in the historic literature are:

The five most popular equity factors
The five most popular equity factors

Honourable mentions go to dividend yield and reversion, which are also popular factors. All of these factors have strong behavioural or fundamental reasons for their existence. If we group value, quality, size and dividend yield together, these factors use company fundamentals to characterise investor preferences:

  • Some investors like cheap/value stocks
  • others prefer high-quality companies with strong earnings growth and stable management
  • investors look for high dividend stocks to give them some income
Describe the 5 most popular factors
  1. Value: buys stocks that are considered cheap based on fundamental ratios such as price-to-book, price-to-earnings or net operating income. Theoretically investors believe that the prices for these stocks are too low and over time the market will adjust and investors will earn higher risk-adjusted returns as prices normalise.
  2. Quality: investors seek out companies that have shown strong management, robust earnings growth, strong margins, stable and manageable debt levels etc - all fundamental company metrics that indicate the company is strong, solid and well-managed.
  3. Size: historically it has been shown in academic papers that small-cap companies outperform large-cap companies due to the risk-premium
  4. Momentum: a purely behavioural factor that invests in stocks that have recently performed the best, based on the premise that this will continue in the future. This can be thought of as chasing recent winners, or fear-of-missing-out, as investors pile into positions in these so-called hot stocks, thus driving up their price in the future.
  5. Low-volatility: another price-based factor where it has been shown that stocks with historically lower than average volatility deliver higher risk-adjusted returns than stocks with historically high volatility. This is contrary to popular opinion, where it would seem natural that riskier stocks earn higher returns due to the extra risk the investor bears by holding them. The opposite is actually true and low-volatility has been referred to as an anomaly. It has been shown to exist in numerous countries and also robust through time.

These factors are all expanded on in significant detail in our more advanced topic "Equity Style Factors".

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