An Introduction to Factor Investing
Author: Mark Stacey
October 1, 2017
Factor Investing is a term that is increasingly used by investors, however the concept of factor investing has been around for some time. Factors are simply the characteristics or attributes of a company that are drawn from financial statements and stock charts. The premise behind factor investing is that the attributes of companies (factors) can be useful in predicting stock returns. Academic research has been instrumental in raising the profile of factor investing and over time has evolved to include combining factors as a part of a disciplined investment process.
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 intrinsic value makes the legendary investor one of the early adopters. Extensive academic research has confirmed Buffet’s investment approach as the value factor has proven to be effective in identifying stocks that are expected to outperform.
Although buying cheap stocks has long been a tenet of investing, the earliest factor research focused on stock price. The readily available stock returns enabled William Sharpe and Harry Markowitz to identify market (beta) as the first factor. Then as company data expanded and academic research intensified, the number of factors increased with Eugene Fama and Kenneth French developing a three-factor model to include value (cheap stocks outperform expensive stocks), size (small cap stocks outperform large cap stocks) and beta (high beta stocks outperform low beta stocks). Today the list has expanded to include low volatility and momentum.
Over time, factor investing has evolved from identifying individual factors to combining multiple factors in a disciplined investment process. Individually, each factor can provide investors with long term performance, but research has demonstrated that factors are cyclical and can lead to an uneven ride.
Many investors want a targeted exposure to a single factor, however, the true power of factor investing lies in factor diversification. Multi-factor strategies can capture the opportunity, but manage the risk as factor exposures can be managed to provide a smoother ride for investors. The depth of factor information allows for multi-factor strategies to be created across different sectors, regions and asset classes. This ongoing evolution provides investors an ever expanding opportunity to take advantage of factor investing.