Factor-based investing is an approach that involves investing in stocks that exhibit a few or just one particular characteristic.
These characteristics could be value, quality, or size “factors” to name a few. For example, an investment approach based on the value factor will involve investing in stocks that trade at a relative discount to their peers, be it on a low price-to-earnings (PE) or price-to-book (PB) ratio.
Does factor-investing work?
The idea behind factor-based investing is that the factors that shape the investing approach should be highly correlated with positive investment returns. For instance, back-testing has shown that stocks that exhibit a low PE ratio have over the long-run outperformed the broader market.
Therefore, exposing your portfolio to stocks that exhibit these characteristics will, in theory, reward you over time.
Sieving the wheat from the chaff
But not all factor-based investing works. Choosing the right factor to invest in plays a huge part in your success.
Andrew Ang, BlackRock’s head of Factor Investing Strategies, explained in a recent article that investors need to be able to distinguish between factors that are simply “passing fads” and those that are “fundamentally-based.” He explained two criteria he uses to make the distinction:
- Economic rationale
The factor should have an economic rationale for its return premium. In the world of Big data, it is easy to find coincidental correlations between a factor and returns. However, many of these correlations are due to chance.
By focusing on factors that have economic rationale which drives their outperformance, we can be certain that there is a legitimate and very real reason behind the correlation between performance and the factor.
- Decades of data
For the retail investor, it is difficult to gather enough information to backtest a particular factor over decades or even longer. However, funds with access to big data, are able to use the information to see if a factor has a long-term correlation with performance.
Using factor-based investing
If you are thinking of using a factor-based approach for your investment portfolio, there are a few things to take note of.
First, define your investment goal and identify factors that can help you achieve your goals.
Second, not all stocks that exhibit a particular factor will produce similar returns. The correlation between factors and returns is based on a large amount of data comprising thousands of companies. As such, your portfolio needs to be heavily diversified in many companies that exhibit that factor.
Combining factors into a solid investing framework
There is good evidence that factor-based investing has worked well in the past.
However, investors need to identify the factors that are the most correlated with positive returns. It may also be useful to combine certain “style” factors together into a more robust investment framework. An investment framework can help you focus your portfolio on stocks that are even more likely to do well over the long-term.
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