In investing, isolating the characteristics of a security associated with
higher returns is referred to as factor investing.
Factor-based approaches to investing have, in recent years, gained
significant attention; however, the concepts guiding these approaches have
been around for some time. Many fundamental attributes of companies and
securities have shown to be correlated with past stock returns and so are
expected to be correlated with future returns.
The basis of Modern Portfolio Theory has long been centered around the
Capital Asset Pricing Model (CAPM) originated by William Sharpe and Harry
Markowitz. Sharpe and Markowitz identified beta as a factor that was
instrumental to a stock’s return. Beta is arguably the best-known factor
and the one every investor gains exposure to, whether intentionally or not,
when allocating to equity securities.
Countless academic studies have since expounded on the groundbreaking CAPM,
noting that other identifiable investment factors yielded significant
Many investment professionals have used factors to pick stocks from the
very beginning. Warren Buffet isn’t thought of as a factor investor, but
his focus on identifying stocks trading at a discount to their intrinsic
value, based on Benjamin Graham and David Dodd’s work in 1934, makes the
legendary investor one of the early adopters.
Extensive academic research has confirmed the value factor has proven to be
effective in identifying stocks that are expected to outperform.
As the volume of company data expanded, and academic research intensified,
the number of factors increased as Eugene Fama and Kenneth French developed
a three-factor model which included value, beta, as well as size. Size
refers to the historical precedent that small-cap stocks have outperformed
large-cap stocks over the long-term.
The conventional wisdom with regard to timing small-cap stock investing is
that U.S. small-cap stocks have historically outperformed large-cap stocks
during rising rate environments. But performance is cyclical and periods of
underperformance can be long.
Today the list of factors has expanded to include low volatility and
In 2005, the term “fundamental indexation” was coined, which attempted to
redefine a company’s weighting in an index based on an attribute other than
market capitalization, while smart beta tilted the index to potentially
improve returns and/ or reduce risk through the application of rules.
Individually, each factor can provide investors with long-term performance,
but research has demonstrated that individual factor performance will vary
considerably based on market cycle and can lead to a volatile, uneven ride.
Why multi-factor investing?
Over time, factor-based investing has evolved from identifying individual
factors to combining multiple factors in a disciplined investment process.
Multi-factor strategies can capture the opportunities provided by a
factor-based approach, but also manage risk and volatility. Factor
exposures can be managed to provide a smoother ride for investors across
different sectors, regions, and asset classes. This ongoing evolution
provides investors opportunities to incorporate factor-based strategies
into their portfolios.
Jay Bhutani is Senior Vice-President, Head of ETF Strategy at
AGF Investments Inc. This article first appeared in the Fall 2017 issue of
Your Guide to ETF Investing, published by Brights Roberts Inc. Reprinted with permission.
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