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
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.
A stock that has recently trended upward tends to continue rising.
Small-capitalization stocks tend to outperform large capitalization stocks over time.
Stocks that are of a higher quality tend to outperform poorer quality stocks over time.
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).
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.
About AGF Management Limited
Founded in 1957, AGF Management Limited (AGF) is an independent and globally diverse asset management firm. AGF brings a disciplined approach to delivering excellence in investment management through its fundamental, quantitative, alternative and high-net-worth businesses focused on providing an exceptional client experience. AGF’s suite of investment solutions extends globally to a wide range of clients, from financial advisors and individual investors to institutional investors including pension plans, corporate plans, sovereign wealth funds and endowments and foundations.
For further information, please visit AGF.com.
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