Investing style many are rushing to adapt nowadays: Factor investing

Dubai: A recent global study conducted among hundreds of investors by US-based investment manager Invesco indicated how a majority of them are finding investment success with respect to returns, particularly when it comes to investing using ‘factor’ strategies.

Over the last fifty years, academic research has identified hundreds of factors that impact stock returns. A factor-based investment strategy involves tweaking investment portfolios towards and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks.

The study, which surveyed 238 factor investors, revealed that such ‘factors’ continue to perform in the long run with over 65 per cent of respondents indicating that the incorporating this style has allowed them to meet or exceed expectations when it came to their portfolio’s performance.

What is ‘factor’ investing?

Factor investing is an investing strategy that chooses assets or securities on attributes that are associated with higher returns. Simply put, it involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns.

Let’s briefly understand the concept it with an example. One ‘factor’ that is often referred to when opting for company stocks in one’s portfolio is ‘value’. Value is familiar to most investors as describing the popular approach: “buy low, sell high”. If you can consistently find a company stock (like a reputed gold mining firm) that’s trading at a lower price (just because gold prices have been trading at an all-time low), they tend to be better investments over the longer term, or in other words - ‘good value for money spent’.

Similarly, another market-based approach or often-used ‘factor’ is ‘momentum’, which to put it in the simplest of terms can be loosely described as “buy high, sell higher.” If that sounds expensive, consider this: If there’s a “stock that everyone’s talking about in a party,” it’s probably not a great value play — but if all the big players in the market are buying it, it’s going to go up. 

Apart from the couple of asset characteristics discussed above like value and momentum, the other factors that are included in a factor-based approach includes size, asset growth, profitability, leverage, term and carry – terms which are elaborated further below.

Unbundling factors apart from ‘value’, ‘momentum’

While ‘value’ and ‘momentum’ can be considered as the yin and yang of investment strategies, value is a long-term trade - It’s cheap to implement but expensive from an emotional standpoint. Conversely, momentum is expensive because it necessitates a lot of trading, ongoing repositioning of your positions, last month’s hot stocks to this month’s.

Factors are concepts that ring true, but are also quantifiable. The value and momentum factors are market-based: Have enough investors piled into a stock to give it momentum? In contrast, the other factors are more fundamental, speaking to the characteristics of a company.

The low-volatility factor is easy to grasp but is yet to be fully understood. Research show that less-volatile stocks outperform the broader market, which can possibly because, as investors pile onto higher-flying stocks, then less-risky ones may become value plays.

Quality refers not just to a company’s management and governance but also to its results: Does it reliably produce strong earnings and maintain a healthy balance sheet? This can sound intuitive, which is why it can be a riskier factor.

Among other things, being highly profitable is both good and bad. Company management may not be fully aligned with shareholders and may make disappointing decisions, such as enriching themselves, expanding too fast or going into riskier ventures.

Many analysts consider the size factor, among the above-discussed ones, but among some market leaders, the concept has been scrapped. While there is an obvious logic to the narrative that smaller companies are more likely to be undervalued, some research disapproved the idea. And another point worth noting is - smaller companies are more likely to be more volatile.

Understanding the narrative behind a factor can be risky

Experts argue that it’s important for investors to understand the narrative behind each factor. You have to come up with a rationale or a belief that you have to truly adhere to that a particular factor is robust enough to trust.

Still, because of the rules that underpin the approach, it’s a strategy that’s nearly impossible for most investors to do casually, and not really appropriate for applying to single securities. Curious investors may want to check out a good reputed interactive tool for judging various factors. Among other UAE-based wealth management company and online investment platforms, Wealthface offers both passive indexing investment and factor investing services.

Why factor investing?

Experts say and historical research is proving that investing in factors can help improve a portfolio’s investment outcomes or returns, reduce volatility or risk and improve diversification of one’s portfolio. So understanding how factors work can help better an investor’s potential for much higher returns and reduced risk, just as multiple leading investors have done for decades.

What is the state of ‘factor’ investing today?

In the years that ensued since factor investing’s inception, prominent institutional investors have publicly embraced more systematic approaches to portfolio allocation and security selection based on these insights.

Around the world, professional investors have been quick to accept factor investing as a great method of investment to build wealth. Asset managers have also dived in and increased the breadth of their offerings in this field.

The amount of money invested in factor strategies is estimated at about $2 trillion globally. US-based Morgan Stanley had earlier estimated that assets under management have steadily grown at an average rate of 17 per cent since 2010 and asset management giant BlackRock views that the investments are projected to grow to $3.4 trillion by 2022.

Why is ‘factor’ investing so popular?

In recent years, active investment managers have been criticized over how much value they add relative to the fees they charge. Many investors have been turning towards passive strategies as a cheap way of gaining market exposure.

The rise of passive investment options has not been limited to US stocks. European and Asian equity markets experienced a similar uptrend, and passive investment options have also been gaining traction in other asset classes.

Recap of risks with passive investing

Yet passive strategies are far from perfect. They may appear to be cheap and prevent unpleasant surprises resulting from poor active calls. However, they ultimately lead to chronic underperformance relative to the market, especially once costs accounted for.

However, there are other concerns too. For example, due to their public transparency, passive strategies are prone to arbitrage. And their recent growth in popularity entails a risk of overcrowding.

Also, because passive investing ignores decades of academic insights on factor premiums, replicating the market index implies investing a significant part of a portfolio in securities with negative expected returns. Moreover, truly passive strategies cannot take sustainability considerations into account as they involve active investment choices.

Meanwhile, the rise of computational power and the ability to store and process an ever-greater amount of data at low cost have profoundly changed the way financial markets operate. One of the most important transformations has been the emergence of quantitative investment strategies.

The rise of quant has, in turn, enabled new breeds of rules-based active selection approaches to emerge. Factor investing is one such example.

Factor investing, an alternative to active and passive investing strategies?

The issues inherent in active and passive strategies have been instrumental in the rise of factor investing. Many investors view factor investing as a third method of investing. It has features that are similar to passive investing, such as it is transparent, rules-based and low-cost nature. But, like active investing, it continuously aims to outperform the market.

There’s extensive evidence which suggests that strategies focusing on proven factors add significant long-term value for investors, helping to reduce portfolio risk, improve risk-adjusted returns and boost diversification. Targeting proven factors in an efficient way is clearly worth the effort, even after the effects of management fees, taxes, trading costs and investment restrictions. Allocating to multiple factors thereby increases the probability of success.

Different approaches to factor investing

However, it’s important to bear in mind that there are many different approaches to factor investing, some more efficient than others, and that investment outcomes can vary greatly. The factor investing label encompasses a wide variety of investment solutions that can be put to work in many different ways, using a broad array of investment vehicles.

In short, factor investing offers a compelling alternative to traditional active and passive investment strategies. But, there are different approaches to factor investing, some more efficient than others.

Improving investment returns

One of the most important transformations in the financial industry in recent years has been the massive shift from active to passive investment strategies. However, that shift has raised a number of concerns.

For instance, although going down the passive route may be cheap and prevent unpleasant surprises from poor active calls, it ultimately leads to chronic underperformance once costs are taken into account. Passive strategies also expose investors to significant arbitrage risk.

Against this backdrop, many investors have turned to factor investing in a bid to achieve superior risk-adjusted returns while keeping costs relatively low.

Reducing risk of losses or declines

Risk reduction has risen high on the priority list of most investors in recent years. Products exploiting the low-volatility or low-risk factors could be an ideal tool to help them do so without foregoing return potential.

Virtually unknown barely a decade ago, low-risk investing has become a broadly accepted and adopted approach in recent years. The low volatility and low-risk factors are grounded in the empirical finding that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the longer term.

Various studies have confirmed this effect holds true in equity markets across the world and also in other asset classes, in particular the corporate bond market.

What recent study among investors show?

The recently-conducted global Invesco survey on ‘factor investing’ found that 97 per cent of factor investors were planning to either maintain or increase their factor allocations over the next 12 months, with investors in EMEA (Europe, Middle East and Africa) more likely to be making additional allocations to factor strategies, than their counterparts in North America or the Asia Pacific region.

The study also revealed that among nearly all of the factor investors it surveyed - which is responsible for managing over $25 trillion in assets in total – agreed that that factor investing can be applied to fixed income.

Fixed-Income securities are debt instruments that pay a fixed amount of interest to investors. The interest payments are typically made semi-annually while the principal invested returns to the investor at maturity. Bonds are the most common form of fixed-income securities.

The survey also indicated how over 60 per cent of investors now make use of ETFs for factor investing and more than half of factor investors were already incorporating, or are considering incorporating, ESG into their factor portfolio.