What is Factor Investing?

You have almost certainly heard about index investing. It is also known as passive investing. Investment portfolios are built to mimic a given market. Its size or market capitalization determines the weighting of each stock. In the Australian market for example, BHP would have the highest allocation, followed by Commonwealth Bank, CSL etc.

Active investment is the main alternative to passive or index investment. Fund managers use a variety of strategies to try to outperform the average market.

Between these two approaches, factor investing is a third option. The results have been mixed. ETFs that use a factor-investing methodology are growing in Australia, so you’ll hear more about this investment strategy.

Let’s bring you up to date.

What are some of the most common factors in factor investing?

A factor is a part of an investment that represents a particular risk. Investors can expect to receive a reward from some factors, while others will not. When applying a factor-based investment approach, the goal is to identify factors that have historically provided investors with an extra reward above and beyond that of a neutral or unaltered portfolio and that are expected to continue in the future.

The most commonly used investment factors include:

• You can also value
• Size
• Momentum
• Quality

Funds that use a factor-based approach will adjust their allocation away from the market capitalization index. Portfolios are, therefore, biased or tipped toward one of these elements.

The Value factor may be the best-known and most widely used. The portfolio is skewed towards stocks whose price relative to earnings is lower than the market average. According to historical data, investors who have a value bias tend to achieve better long-term returns. This approach can be challenging because a value bias may underperform for a long period. Value-based portfolios are typically underweighted in growth stocks. Value-biased portfolios are unlikely to include a stock such as NVIDIA, for example, that has increased 250% over the past 12 months. This can be a problem, especially when the markets reward growth. And they do so very often. Investors who hold a value-based portfolio must, therefore, be extremely patient, which is something we all struggle with.

The size factor is based on the fact that in the United States, small-cap stocks tend to outperform large-cap stocks over the long term. This factor was also established by research into historical price movements. Like most other factors, it is not difficult to come up with a logical reason why this one should work. It is true that, in the case of the size bias, all large companies used to be small. For a company to reach the status of a large corporation, it must have grown rapidly. Participating in this period of strong growth offers clear rewards to investors. It would seem logical to hold a portfolio that is skewed towards small-cap stocks.

This particular factor does seem to have two problems. The historical data does not support the idea that this factor would be successful in the Australian market. I’ve not come across anyone who has a theory that explains why this is, but my best guess is that our market is so large that any company that isn’t in the top 10 on the ASX would be considered a small-cap in the United States. In the United States, companies that are considered small caps in Australia would only be fleas. Investors are most likely to be attracted by companies that are larger and more established.

Some of our smaller companies are mineral explorers and don’t do well with outside investors.

Momentum investing is based on the idea that stocks tend either to go up or down in a certain direction. A trend can last for many months or even years. Portfolios that apply a momentum factor look for stocks with an upward trend and increase exposure. Stocks on a downward trend will also be underweighted in relation to a market capital index.

It is easy to imagine how value and momentum portfolios look. A value-biased portfolio will look for stocks that are not popular and wait patiently for the sentiment to change. However, a momentum-biased portfolio will jump on board the stock bandwagon.

Our fourth factor, Quality, is also important. Portfolios built using the quality factor are more likely to favor stocks that have low debt levels, stable revenue, and dividends. Diverse fund managers may arrive at a different assessment of quality, but these characteristics will likely be at the core of each one.

This seems like a no-brainer. Would we really invest in companies whose quality isn’t high? In reality, the problem is that the companies that score highly in these measures of quality are usually well-established and stable businesses with limited growth potential. In Australia, our four biggest banks are a good example. These are probably good investments that will provide a steady dividend. They are not Tesla.

It is important to note that these are not the only four factors that investment managers can use, but they are the most common. Other factors, such as volatility and liquidity, are not uncommon.

Then factor-based investing is a method of constructing portfolios that differ from standard indexes. This is done by adding filters or criteria that lead to biases either in the direction you want or not. Each factor has its logic. Academics then examined the data to determine if the gut feeling had any validity.

The standard market capitalization-based indexes don’t work perfectly. You can end up with a very concentrated portfolio in a small country like Australia. Even in the larger U.S. markets, Apple, Microsoft Alphabet, and Amazon dominate your portfolio.

Factor approaches may address these shortcomings. In the United States, some factor-based ETFs have a long track record of success. It is a challenge to determine whether past performance can be repeated in the future and whether strategies that were successful in America will translate into our local Australian market.