What is factor-based investing?

Author: Sound Choices

October 23, 2019

The premise behind factor investing is that the attributes of companies (factors) can be useful in predicting stock returns.

Factors are simply the characteristics or attributes of a company, drawn from financial statements and stock charts, that are known to be correlated with past returns and expected to be correlated with future returns.

Factor-based investing begins by identifying the key “factors” of equity or fixed-income securities that have historically been related to higher returns over time and then evaluating and selecting securities for investments based on these attributes.

Widely used style factors

Value

A stock with a market price that is below the company’s intrinsic value. Over time, stocks with a lower price relative to their intrinsic value have outperformed.

Momentum

A stock that has recently trended upward tends to continue rising.

Size

Small-capitalization stocks tend to outperform large capitalization stocks over time.

Quality

Stocks that are of a higher quality tend to outperform poorer quality stocks over time.

Volatility

Stocks with a lower volatility tend to outperform higher volatility stocks over time.

History of factor-based investing

Although factor-based investment approaches have garnered significant attention in recent years, the concepts guiding these approaches have been around for some time.

Based on the modern portfolio theory framework developed in the 1960s, the Capital Asset Pricing Model (CAPM) was the first model to describe the market with a single risk factor associated with it: beta, or the sensitivity of an asset’s return to the market’s return. CAPM was expanded on in the 1970s with the introduction of arbitrage pricing theory (APT), in which there are a set of risk factors that capture systematic risks that investors should be compensated for bearing.

Since this early research, value, momentum, size, quality and volatility have all been put forward by academic theory to be valid factors in investing.

How factor-based investing works

Investors who take a factor-based approach are seeking to identify securities that exhibit characteristics of factors to either capture excess return or reduce risk.

Generally, factor-based approaches begin with a stock selection model – ranking securities in a given universe from best to worst based on a fundamental characteristic or characteristics. This model will suggest which securities the investor should own or be overweight (the highest-ranked securities) and which securities the investor should not own or be underweight (the lowest-ranked securities).

Factor diversification

The true power of factor investing lies in factor diversification.

Over time, factor investing has evolved from identifying individual factors to combining multiple factors in a disciplined investment process. Research has demonstrated that factors are cyclical, which means certain factors may underperform at different points in the economic cycle. Multi-factor strategies, or consider multiple factors when selecting securities, can allow investors to capture opportunities while managing risks, providing a smoother ride for investors.

Key considerations when evaluating factor-based approaches include understanding a strategy’s performance objective and risk targets as well as its role within a portfolio. To find out more about factor investing, contact your financial advisor and visit agf.com/AGFIQ.

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed; their values change frequently and past performance may not be repeated.

The commentaries contained herein are provided as a general source of information and should not be considered personal investment or tax advice. Every effort has been made to ensure accuracy in these commentaries at the time of publication; however, accuracy cannot be guaranteed. Market conditions may change investment decisions arising from the use or reliance on the information contained here.

The contents of this Web site are provided for informational and educational purposes, and are not intended to provide specific individual advice including, without limitation, investment, financial, legal, accounting or tax. Please consult with your own professional advisor on your particular circumstances.

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