Factor-Based Investing – A Quantitative Approach
Over longer horizons, investment factors have proven their superior performance over the long run, yet their short-term performance can remain unpredictable in market environments.
Investors can utilize the underlying characteristics of securities to identify potential sources of outperformance and create multi-factor portfolios. Common factors for doing this are value, size, momentum, low volatility and dividend yield.
The Value Factor
Utilizing a systematic approach, factors can be added to a portfolio as sources of long-term excess returns without increasing overall risk. Unfortunately, however, this strategy can sometimes experience periods of underperformance, and investors who cannot stomach such volatility may opt out altogether and forgo the potential long-term expected returns offered by factor investing altogether.
Thankfully, the “zoo of factors” has been reduced to those that demonstrate true explanatory power in predicting market returns and meet stringent criteria of persistence, pervasiveness, robustness, investability and logic of operation. Thus, whether one chooses long or short positions on any factor over time varies, there will always be buyers and sellers on the market who seek such strategies.
As opposed to active management, which requires ongoing buying and selling based on market predictions, factor-based strategies use index vehicles such as ETFs to select and weigh factors ahead of time. They may be used in place or addition of conventional market cap weighted index portfolios; however, factor-based strategies also tend to concentrate risk in particular factors.
The Momentum Factor
Momentum strategies rely on maintaining market trends that have already established themselves. Investors’ behaviors – such as being reluctant to sell losing stocks while eagerly holding onto winning ones – can create and sustain momentum, as can market reactions which take time to fully reflect new information.
Momentum strategies can be difficult to capture due to their transient nature and high turnover, leading to higher transaction costs and taxes that eat into returns.
Momentum can provide significant challenges to the Efficient Market Hypothesis, which states that market prices should fully reflect all pertinent information. Research has identified numerous other factors which contribute to stock returns besides momentum; such as size, quality and low volatility – often combined into popular models like Fama-French’s three-factor model or Mark Carhart’s four-factor model.
The Size Factor
Though factor investing has proven popular, it is essential to distinguish fact from fiction. While many factors have generated impressive premiums over time, others may experience periods of underperformance.
As the industry has evolved, researchers have refined what was once considered a “zoo” of factors into those which meet specific criteria such as persistence, pervasiveness, robustness, investability and logic of how they operate. Today we know of seven equity risk factors (value, momentum, quality, profitability size and low volatility), three fixed income risk factors (momentum quality duration).
Although these factors may experience temporary underperformance, research-driven portfolio construction provides a disciplined, research-driven approach to portfolio creation that can increase returns while mitigating risks. They offer investors flexibility in customizing strategies according to their risk tolerance and goals; size factors tend to perform best during market downturns while quality/low volatility strategies yield stronger returns in riskier markets.
The Quality Factor
The quality factor seeks out stocks with characteristics investors are willing to pay a premium for, such as profitability, low debt levels and conservative accounting practices. According to academic studies conducted on this concept, it produces surplus returns over time.
Investors that want to capture premiums can pursue single-factor and multifactor strategies, the latter usually yielding better results by maximising exposure to multiple factors at the same time, limiting some of their cyclicality, and offering robust risk-weighted returns for entire cycles.
Multifactor strategies may offer numerous advantages over traditional market cap weighted indexing, but it’s important to remember they aren’t an absolute panacea. They tend to have limited track records and have yet to go through a complete market cycle which may cause them to underperform their benchmarks over the long term. We recommend including multifactor funds as part of an overall portfolio in order to enhance return potential, rather than as standalone long-term investments.
