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What are style factors
Back to topic: Learn about equity style factors

STRATxAI

April 2023 · 5 min read

Style Factors

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Educational

What are Style Factors ?

Style factors investing, commonly shortened to factor investing, is a rules-based approach that groups stocks together where each of the stocks share a set of common properties. These properties can be

  • related by common fundamental balance sheet items
  • company management style and governance
  • market cap and price metrics
  • historical performance and statistical properties of stock returns

Style factors group stocks together into portfolios based on the above characteristics. It has been shown through history that investing in these portfolios can give investors a source of consistently high risk-adjusted returns and offers diversification rather than investing in the overall market or a simple index tracker.

Common style factors

The most common style factors are:

  1. Value

  2. Quality

  3. Size

  4. Low volatility

  5. Momentum

This is not an exhaustive list and there are indeed other well-known factors, such as reversion, short interest, seasonality and earnings yield but the ones listed are probably the most common and widely used.

Additionally, style factors tend to be large-scale and are based on fundamental or price data and so can be applied across the entire universe of active securities each day. This means that style factors have large investment capacity and both large fund managers and small investors can invest in these strategies very easily. It is very positive that style factors can cope with this investment capacity and still deliver excess returns.

Capacity of equity style factors
Investment capacity of style factors as calculated by Blackrock in "Capacity of Smart Beta Strategies: A Transaction Cost Perspective""
Style factor properties

For a factor to be embraced by the investing community as being a proper style factor, then it should have the following properties:

  • robust over a large timeframe
  • occur in different geographical regions and markets
  • make economic or behavioural sense and can be backed up by academic published papers

If the efficient market hypothesis was to be believed then the current price of the stock would be fair and contain all the information available. However, due to behavioural biases and investment and benchmark criteria, factor premiums have been shown to consistently exist and investors aim to systematically harvest that premium via quantitative strategies. Factor premiums represent the extra return investors obtain by investing in a factor.

Different style factors perform differently during various stages of the economic cycle. There are no concrete rules but some generic principles can be inferred. A diversified portfolio most likely has a blended combination of various style factors at all times.

Style factor conceptual performance during economic cycles. Source: Blackrock
History of Style Factors

The original capital asset pricing model (capm) from the 1970s was the simplest model to explain a stocks return. It used a beta coefficient, that represented a correlation type measure between the stocks returns and the market returns, to model the stocks return. Alpha represents the extra return of the stock, that is not explained by its relationship to the market return. The capm model using alpha and beta, was given by

Advances to this model came from the work of Professors Fama and French who introduced a 3-factor model, where they modelled stock returns by introducing two new explanatory factors to extend the capm. They added size and a value type factor to the existing market factor. This model represents a stocks return by saying some of its return comes from the market, some from the size factor and some from the value factor with a new alpha representing what is left over.

Prof Fama and French provide the return data on their website https://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html

Fama French data library contained factor returns
How are Style Factors Used ?

Style factors can be used for various goals.

  1. Small investors or retail investors might just love a certain set of stocks e.g some value investors just always want exposure to cheap stocks. Others might just always want to be with the crowd and buy recent winners (momentum).
  2. Investors can construct or tilt their portfolios to focus on various style factors.
  3. For risk mitigation, portfolios can be analysed in terms of their factor exposure and modifications made.
  4. Hedge funds typically aim to construct strategies that have limited exposure to style factors.
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