Calculating Risk and Investing Wisely

Unlock the Power of Factor Investing: A Guide for Investors

You may have heard about factor-based investing. It has increased significantly in popularity in recent years.

What is it? Should you adopt it for your portfolio? What are the pros and cons?


What is Factor-Based Investing?


Factor-based investing is a type of investment strategy that looks beyond traditional metrics, like company size or market capitalization, to identify specific characteristics of a stock that have been shown to predict future performance.

Factor-based investing can include macroeconomic factors that capture overall risk across asset classes, like inflation, liquidity, risk of default, and geopolitical risks.

Factors are used to help explain returns and risks within asset classes.

The most common factors are value, momentum, quality, size, and low volatility.

Let’s take a look at each of these factors.

Value

The premise of using value as a factor in investing is that stocks that are inexpensive compared to other measures of fundamental value outperform more expensive ones.

Value stocks
usually trade at a lower-price-to-earnings multiple, although other fundamentals (like price compared to comparable stocks, volatility, and dividends) may be used by investors to identify value stocks.

Momentum

“Momentum” refers to the likelihood of a stock (or ETF) with a favorable price trend continuing in that direction.

Investors relying on momentum believe upward trends can last for sustained periods.

The downside of momentum investing includes high turnover costs, difficulty tracking price movements, and the risk of holding momentum stocks in a bear market.

Quality

Investors who incorporate the quality factor into their investing believe high-quality stocks will outperform low-quality stocks.

Size

The size factor follows the academic evidence that stocks with a low market capitalization earn substantial premiums over time when measured against large-cap stocks, without increasing risk.

Low volatility

Low-volatility stocks (measured by standard deviation) may earn greater risk-adjusted returns than highly volatile ones.

Other factors

These are the factors commonly used in factor-based portfolios. However, hundreds of alleged factors have been identified in what has been called the “factor zoo.”

Many of these factors “are redundant, lack robustness, or cannot be replicated.”

Selecting factors to enhance risk-adjusted returns, and rejecting those that won’t, can be challenging.

One set of criteria suggests limiting factors to those with an extensive record of delivering a premium.  In addition, a factor must be “persistent, pervasive, robust, investable, and intuitive.”

Benefits of Factor-Based Investing

There are many benefits to a factor-based portfolio.

1. Significant historical data demonstrates that certain factors contribute to outperformance over the long term in certain market conditions.

2. Factor-based portfolios tend to improve diversification, mainly when you use factors with a low correlation. A broadly diversified portfolio minimizes risk.  

3. It’s easy to find mutual funds and ETFs that are factor-based.

4. A factor-based portfolio can improve returns without materially increasing risk.

5. A factor-based portfolio provides more customization than a traditional index-based portfolio.

6. With a factor-based portfolio, investors don’t need to rely on the stock-picking skills of active mutual fund managers.

7. Factor-based funds from low-cost providers like Vanguard and Dimensional Funds typically have lower expense ratios (management fees) and greater transparency than actively managed mutual funds.

8. Investors in a factor-based portfolio can seek high expected returns, with greater volatility, or lower returns, with lower volatility, than the returns of the entire stock market.

Cons of a factor-based portfolio


1. Factor-based investing is not a short-term strategy.  It can take years to demonstrate that a given factor should be incorporated into a portfolio. Depending on the factors you select, there could be long periods when your factor-based investments underperform the overall market.

2. A factor-based portfolio's outcome mainly depends on the factors you select.

3. Some factors may increase the risk of your portfolio. For example, investing in small, high-growth companies increases risk if you use size as a factor.

4. Limiting factors to one or two will likely increase the risk of your overall portfolio.

5. If you rely on past performance to select factors, the outperformance may not continue.  Avoiding “selection bias” can be challenging depending on factors with positive historical results.

6. Selecting the right mutual fund can be difficult because different funds may choose their own factors.

7. Factor-based investing is complex and often not suitable for do-it-yourself investors.  Correlations among factors may change over time, increasing risk.  Some factors may fall out of favor with academics, and others may be included.  

At Daner Wealth, we assist clients in determining the portfolio that best suits their requirements.

Factor-based investing is a type of investment strategy that looks beyond traditional metrics, like company size or market capitalization, to identify specific characteristics of a stock that have been shown to predict future performance.

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