Factor investing is a long-term approach to investing that uses factors to select stocks with behaviours that are historically associated with above-average returns.
Factors are characteristics that affect the expected performance of a security and include things like size, quality, momentum and volatility.
Types of factors in factor investing
There are five main types of factors in factor investing:
Value
The value factor seeks to invest in stocks that are trading at low valuations relative to their fundamentals.
Size
The size factor seeks to invest in stocks that are large by market capitalization. This is sometimes called “large-cap” or “large-cap growth”. Smaller companies are thought to have less growth potential than larger ones but may also have lower operating costs and more stable profits. This can still make them attractive investments if you’re looking for income rather than growth potential.
Quality
Companies with high-quality earnings tend to perform better than those without strong financials because investors rely on this consistency when making investment decisions.
Momentum
The momentum factor seeks to invest in stocks that have been outperforming their peers and have recently risen above a certain price level.
Volatility
This factor attempts to pick the least volatile stocks from each industry sector while maintaining similar return potentials across all sectors (also known as style neutrality). This helps smoothen out periods of volatility so that investors don’t need as much cash flow during down markets while still maintaining similar returns during up markets.
Characteristics of factor investing
- It is a long-term strategy.
- It is a diversified investment.
- It is a form of passive investment
- It is also a systematic and global investment strategy.
How does a factor investor choose which factors to invest in?
It’s important to note that the factors that have historically worked best are not necessarily the factors that will continue to work going forward.
For example, value investing has been shown to outperform over time, but it did underperform during periods when interest rates were low and investors were willing to pay more for growth. It also gained popularity during years of economic expansion, which may make it less attractive in a recessionary climate.
These are some of the observations a factor investor makes before taking a decision.
Why do factor returns vary over time?
Macroeconomic events
Changes in the economy like inflation and interest rates can affect factors. For example, if the economy experiences high inflation and rising interest rates, then it might be a good time to invest in value stocks since they tend to be cheaper than other stocks.
Company-specific events
Factors can also change because of company-specific events such as mergers or acquisitions that make one company more attractive than another for investment purposes (e.g., Adobe buying Figma).
Does factor-based investing work?
As with any investment strategy, there is no guarantee that the factors you are investing in will perform well.
Remember that even if a factor works out, it may not be enough to help you achieve your desired return. The market itself can also fail to live up to expectations.
A single factor can’t guarantee good performance.
Conclusion
Factor investing can be a useful tool for investors who want to beat the market over time. It gives them an edge by allowing them to choose from a number of factors that have delivered better performance than average over long periods. However, it’s important not to rely solely on a single factor for your returns because there’s no guarantee that these will outperform in the future.
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