Not-so-new factor-based investing

Not-so-new factor-based investing

In fact, it’s been around for awhile

Maybe you’ve seen those Fidelity commercials that aired awhile ago. They start with a bunch of math formulas and scare you into thinking that investing is very complicated after a very high-level explanation of factor-based investing. Then it cuts to a lot of good-looking people pointing at things. While the production values are pretty slick, I’m not sure it really does a good job explaining what factor-based investing is, or more to the point, why you should care.

Factor investing may seem to be a new concept, but in reality, it’s been around longer than many realize. Value investing, or the concept of buying a stock well below what you believe it to be worth, is a type of factor-based investing. In very simple terms, factor-based investing screens securities for different characteristics that have historically been shown to lead to strong returns over periods of time. There are literally hundreds of different factors, but there are really five main ones.

Value – This involves buying securities at prices you believe are below what you believe them to be worth. The evidence shows that over time, stocks that trade at lower valuation have earned higher returns than more richly-valued stocks.

Momentum – In very simple terms, momentum investing is like trend-following. The goal is to buy stocks that are experiencing rising share prices. This is based on the premise that stocks that have had strong recent price performance have historically earned higher returns than those experiencing poor recent performance.

Volatility – Historically we have been led to believe that to earn a higher return, you need to accept a higher level of risk. The volatility factor, to some extent, turns that belief upside down. With volatility investing, you are looking to invest in the stocks that have experienced the least amount of price fluctuation over a certain period of time. Research has shown that stocks that exhibit lower volatility have historically outperformed more volatile stocks over time in most market conditions.

Quality – Quality investing looks for companies that are fundamentally strong and exhibit such characteristics as high return on equity, low debt to equity, and low levels of earnings variability. Evidence shows that stocks that score well in the quality factors have historically outperformed those with poorer quality scores.

Size – Another well-known factor is based on the belief that smaller companies have historically outperformed their larger brethren over the long-term.

There is a large and growing body of research that shows each of these factors has demonstrably added incremental return over time. If you really think about how factors work, it is much like how many active managers run their funds. They look for stocks that exhibit certain characteristics and size them based on their conviction. In comparison, a factor-based investment screens the universe on the various factors and then weights the stocks based on the relative attractiveness.

The challenge with factor-based investing is that there are going to be periods of time when the strategies outperform or underperform. The point is that while factors have the potential to outperform the broader markets over time, there will be periods when they are in and out of favour.

Different factors have historically performed better in different market and economic environments. For example, as the economy begins to slow, low volatility and quality factors have outperformed. Conversely, when markets are on the way up, small cap, value, and – later in the cycle – momentum factors outperform.

The accompanying graph shows historically which of the factors have outperformed in different market and economic environments. This shows which factors you would want to emphasize based on the market environment. Right now, with all signs pointing towards our being late cycle, you would want to tilt the portfolio towards low volatility and high-quality investments.

How to access factors

There are many ways to access factors when investing. In the mutual fund space, there are many active managers who run with a quality or value bias to their portfolios. Some will use momentum in their trading strategies. There are also many small- and mid-cap options available to allow you to capture the size factor. For low volatility, many new offerings focusing on this factor have been launched in the past few years.

However, to get pure factor exposure, you will likely want to look to the ETF space as there are many different options available from most of the bigger ETF providers. The challenge when using the ETFs is to understand the key differences in the construction methodology in each and how that will affect the returns over time.

Bottom line

While it’s currently being pitched as the hot new trend in investing, factor-based investing has been around for a long time in many different forms. Depending on which funds you hold, you may already have significant exposure to the different factors, and many active managers use some form of factor analysis in their research process.

Factor-based investing can help improve returns and reduce volatility, but it is a tool, not a magic bullet. You still need to have diversification across different asset classes, geographic regions, industry sectors, as well as factors.

I like to use factors as a way to help tilt the portfolios based on the current and expected market environment. For example, I believe we are late in the cycle, so my portfolios tend to tilt more towards low volatility and higher quality. As the market cycle turns, I’m very likely to put on a small-cap and value tilt to take advantage of the more attractive valuation profile.

Dave Paterson, CFA, is a money manager and an expert on investment fund research and due diligence on a variety of investment products.

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