Factor investing is a hot investment strategy that has been growing in popularity in recent years. But what is factor investing, and why is it so popular? In this blog post, we will explore what factor investing is, the research behind it, and how different factors can beat the market in terms of returns. We will also take a look at some examples of ETFs that target specific factors, as well as the rise of factor investing in general. So what does a factor mean in investing? Keep reading to find out!
What is Factor Investing?
The word “factor” in investing refers to a characteristic that can affect the returns of a security. For example, a company’s size, value, momentum, and quality are all considered factors. In general, five factors are most commonly used in factor investing: value, momentum, size, quality, and low volatility. Value stocks are those that are considered to be undervalued by the market, while momentum stocks are those that have been experiencing recent gains. Size refers to a company’s market capitalization, while quality is a measure of a company’s profitability and earnings stability. Low volatility stocks tend to be less volatile than other stocks.
Why is Factor Investing Popular among Increasing Number of Investors?
One reason factor investing has become so popular is that it offers the potential to outperform the market. For example, a recent study by Fama and French found that the value factor has outperformed the market by an average of three percent per year since 1927. Another reason factor investing is popular is that it can help investors diversify their portfolios. By investing in multiple factors, investors can reduce the overall risk of their portfolios. Finally, factor investing has become more accessible in recent years due to the rise of ETFs that target specific factors.
There is a lot of research that shows the momentum factor can beat the market. A study by Narasimhan and Titman, for example, found that stocks with positive momentum (those that have been experiencing recent gains) have outperformed the market by an average of 2-3% per year.
There is a great deal of research that shows the size factor can beat the market. For example, a study by Fama and French found that small stocks (those with a market capitalization of less than $1 billion) have outperformed the market by an average of six percent per year since 1926.
The quality factor can also beat the market. A study by Fama and French found that high-quality stocks (those with high profitability and earnings stability) have outperformed the market by an average of two percent per year since 1963. Additionally, a study by Asness, Frazzini, and Pedersen found that the quality factor has outperformed the market by an average of four percent per year since 1990.
The low volatility factor can also beat the market. Minimum variance portfolios based on the 1000 biggest U.S. stocks over the years 1968-2005, according to Clarke, de Silva, and Thorley, reduce volatility by around 25% while delivering comparable or better average returns than the benchmark market portfolio. In US markets, Baker, Bradley, and Wurgler have shown that high-beta stocks have historically underperformed low-beta ones.
How to Implement Factor Investing?
There are a few different ways to implement factor investing. One way is to invest in individual stocks that have high scores on specific factors. Another way is to invest in ETFs that target specific factors. Finally, you can also invest in mutual funds that focus on factor investing.
One way to implement factor investing is to invest in individual stocks that have high scores on specific factors. For example, if you want to invest in the momentum factor, you could look for stocks that have experienced recent gains. If you want to invest in the quality factor, you could look for stocks that have high profitability and earnings stability.
Another way to implement factor investing is to invest in ETFs that target specific factors. For example, several ETFs target the value factor, such as the iShares MSCI USA Value Factor ETF (VLUE) and the Vanguard Value ETF (VTV). Several ETFs target the momentum factor, such as the iShares Edge MSCI USA Momentum Factor ETF (MTUM) and the Invesco S&P 500 Momentum ETF (SPMO).
Finally, you can also invest in mutual funds that focus on factor investing. For example, the DFA U.S. Core Equity I Fund (DFEOX) invests in stocks that have high scores on the value, quality, and low volatility factors. The Fidelity Factor ETFs also offer several mutual funds that focus on factor investing.
Investing in factors can help you achieve better returns than the market. However, it is important to remember that no investment strategy is guaranteed to outperform the market. Before investing in factors, be sure to do your research and consult with a financial advisor.
Should You Diversify Between Different Factors?
While each factor by itself can perform well over time, at any given point of time some factors are doing better than others. For example, while small stocks have outperformed the market by an average of six percent per year since 1926, they have underperformed the market in nine out of the last 20 years.
Similarly, while value stocks have outperformed the market by an average of three percent per year since 1945, they have underperformed the market in eight out of the last 20 years.
This raises the question: should you diversify between different factors? The answer depends on your investment goals and risk tolerance. If you are willing to accept more volatility in your portfolio, then investing in a single factor may be a good choice for you. However, if you are looking for a more stable investment, then investing in multiple factors may be a better choice.
What’s the Difference Between Factor Investing and Smart Beta Investing?
Factor investing and smart beta are often used interchangeably, but there is a difference between the two. Factor investing is an investment strategy that focuses on specific characteristics that can affect returns. Smart beta, on the other hand, is an investment strategy that uses alternative weighting schemes to traditional market capitalization-weighted indexes. While both strategies can be used to improve returns, factor investing is the more popular of the two.
Books on Factor Investing
If you’re interested in learning more about factor investing, “Your Complete Guide to Factor-Based Investing” by Andrew Berkin and Larry Swedroe is a great book for beginners. “The Intelligent Investor” by Benjamin Graham is another great book that covers the topic of value investing, which is a type of factor investing. For more advanced investors, “Quantitative Value” by Wesley Gray and Tobias Carlisle is a good choice. Finally, “Quantitative Momentum” by Wesley Gray and Jack Vogel is a good book for investors who want to learn about investing in momentum strategies.
No matter what your investment goals are, factor investing can be a helpful tool to achieve better returns. However, it is important to remember that no investment strategy is guaranteed to outperform the market. Before investing in factors, be sure to do your research and consult with a financial advisor.