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
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.
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.
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 ?
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 factors found to be consistently referenced in the historic literature are:
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:
These factors are all expanded on in significant detail in our more advanced topic "Equity Style Factors".
Tutorials on investing and portfolios