Factor investing explained
During the coming year, we expect an approach known as ‘factor investing’ to play an even more important role in determining investment returns.
What is factor investing?
It is an approach that identifies and targets investments which exhibit certain ‘factors’ that drive investment risk and return. It is most widely applied to company selection within stock markets, although it can be extended to other asset classes. By either capturing, or avoiding certain factors in an objective way, the aim is to improve portfolio returns, reduce risk and/or enhance diversification. Consequently, it’s seen as a third approach to investment management, sitting between full passive investing (whereby an investor seeks to match the return of a market capitalisation-based index) and traditional active management (where a fund manager will aim to outperform a stock market or index based on their subjective assessment of a particular stock’s investment potential).
What are the most important factors in investing?
Factor-based investing is rooted in the world of academia, and academics have now identified over 600 factors which may influence risk and return. In reality however, many of these will simply have been used as marketing justification for the launch of a new investment product. There are five style factors commonly accepted as being the most important:
- Value - This is the tendency for stocks that trade at a discount to similar companies based on fundamental valuation measures, such as cash flow or book value, to outperform more expensive assets. Purchasing securities at lower prices could lead to higher returns.
- Quality - High quality stocks, defined by reference to metrics such as strong cash flow or high profitability, will generally outperform lower quality companies.
- Size - Smaller companies in aggregate will, over time, have a tendency to offer a higher return than larger companies.
- Momentum - Stocks which have recently outperformed an index will tend to continue outperforming and vice versa; the winners will keep winning, the losers will keep losing.
- Volatility - This describes the propensity for low-volatility stocks to outperform high-volatility stocks on a risk-adjusted basis.
Why does this matter for investors and what are the investment implications?
The factor approach has gained popularity because indices constructed using the factors of value, quality, size, momentum or volatility have outperformed traditional equity indices constructed by reference to market cap over the long term.
The chart below shows the returns of indices comprising companies that fit each of the five factors, relative to the market cap alternative. Each factor has outperformed over time.
Value, quality, size, momentum, volatility relative to market cap
Over 20 years, these factors have added value. However, the outperformance of a factor in one year does not guarantee outperformance in the next, and it may be better to combine exposure to different factors, rather than relying on one single characteristic. For example, over the past few years, value stocks have consistently underperformed growth (where one is paying a high price for future growth prospects; the opposite of value), quality and momentum factors, but over the long term value has delivered outperformance of the broad market.
Given the significant underperformance of value and outperformance of quality and momentum as factors, it is reasonable to expect that 2020 may bring with it a reversal, with value set to outperform. The underperformance of value is currently at its most pronounced since the 1930s. To use an analogy, if we were to imagine an elastic band with value at one end, and growth (non-value) at the other, then value is becoming cheaper at one end (so stretching one way) and at the same time growth is becoming more expensive at the other end (stretching the other way). Therefore, the relative valuation difference between the two is getting bigger because one is moving one way and the other is going in the opposite direction. At some stage, there will be a snap back and value will significantly outperform.
Value factor relative to quality and momentum
How could the performance of value stocks affect my investment strategy?
This has two implications for investors. First, they may wish to consider incorporating a dedicated exposure to value stocks.
Second, some strategies and funds have benefited from a focus on quality. These companies have also displayed momentum; they keep on outperforming. At some stage, this style will fall out of favour and these companies, and the funds which have a heavy weighting to them, will underperform. Investors therefore may wish to consider reducing their exposure.
Do factor strategies perform consistently during an economic cycle?
No. During periods of economic recovery, smaller and more flexible companies (the size factor) tend to perform better, as do value stocks. If growth is strong and/or stable but decelerating (as in 2019), quality stocks lead the way.
Quality and low volatility factors also work particularly well during periods of stress – and clearly, the current environment with trade wars and Brexit is a period of heightened uncertainty.
Since July 2009, movements in the yield curve (which plots bond yields for various maturities of debt) have significantly affected factor performance. A flattening yield curve aids quality and momentum factors, while a steepening curve assists the value and size factors.
Is it easy to trade in and out of individual factors?
Actively increasing or reducing exposure to individual factors on perceived shifts in the performance drivers of stock markets is extremely difficult. Yet the explosion in the number of exchange traded funds (ETFs) which are based on factor investing has made it easier. According to ETFGI, the independent research and consulting provider on ETFs, at the end of December 2018, there were 1,298 factor exchange traded vehicles and 159 providers of such funds. These were listed on 40 exchanges in 32 countries, and accounted for assets under management of US$617.65bn.
This could mean that it is much easier for certain style factors to become overcrowded and that, when reversals do occur, they are likely to correct more sharply and much more quickly than previously.
AUM of factor strategies (US$bn)
Source: Morningstar Direct
What conclusions can we draw?
Our job, as investment managers, is to understand what is driving performance, how much risk we are taking and whether we could generate better returns, or reduce risk, by changing the allocation to certain factors. This could become even more important in 2020.
Given the divergence in factor performance over the past few years, we would expect value to lead the way in 2020. However, it would be foolhardy to commit too much to one factor. The rewards for being right could be significant, but so could the cost of being wrong.
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Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.
The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.
The information contained herein is based on materials and sources that we believe to be reliable, however, Canaccord Genuity Wealth Management makes no representation or warranty, either expressed or implied, in relation to the accuracy, completeness or reliability of the information contained herein. All opinions and estimates included in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information contained herein.
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IMPORTANT: Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.