When you invest with a particular goal in mind, you require a strategy that fits your expectations. Like any good recipe, the best place to start is by assembling the ingredients and then applying an appropriate cooking method. In the world of investing, this is akin to an approach known as factor investing.
What is factor investing?
For factor investors, two main drivers of returns lie at the heart of the investment approach: macroeconomic and style. As an individual investor you can’t do much about external, macro factors such as the rate of inflation, unemployment or economic growth numbers, but you can be a little more choosey when it comes to style factors.
Style factors might require you, for instance, to consider if value stocks (which appear to be trading at less than their actual value) are a good fit, or if investments with minimum volatility, greater diversity or higher returns are better suited to your portfolio. Or, indeed, if your strategy lends itself to buying blue-chip, top-quality stocks instead.
In other words, the factors – or ingredients – in your investment soup can be combined in any number of ways to flavour your ultimate financial goal.
What are the main factors?
Most investors probably already give a nod to these factors as part of their investment thinking, even if they haven’t given these considerations or the process a formal name. These concepts are not complex, but merging them in the right way can prove highly effective.
The five factors are:
1. Value: Not every investment opportunity has to cost the most to offer the best value, sometimes shares in a company might be under-priced relative to the value of the overall fundamentals. Investing in these companies offers a great chance to unlock value, rather than investing in higher-priced stocks with less relative value.
2. Volatility: Factor investors might regard low volatility in an asset class to be a good bet for riding out tough economic times, since these stocks tend to perform consistently and steadily, irrespective of the macroeconomic environment. Maybe they won’t shoot the lights out throughout all cycles, but low-volatility investments tend to carry below-average risk.
3. Quality: Quality assets and companies have a few things in common: they tend to have low debt levels and stable and steady growth profiles. This quality factor is particularly important when economies are under pressure, when this constant outlook becomes all the more important.
4. Momentum: Generally, but not always, the price trend of a share continues on a given trajectory, unless bumped off its path by, for instance, external factors such as a global pandemic or industry-related shifts. If a stock is performing well and consistently, its trajectory is often supported by the positive views of the market and investors, which helps to maintain its upward lift.
5. Size: In investing, bigger is not always better. Sometimes an investment in a smaller company (relative to industry competitors), a firm which still has room to grow, might be a factor that appeals to investors. After all, smaller firms are often more agile and faster on the uptake when it comes to innovating.
Why does factor investing work?
Over the years, researchers and economists have applied themselves to understanding the various factors which contribute to better returns and performance. Eugene Fama and Kenneth French, in a 1993 paper published in the Journal of Financial Economics, determined three factors which they said were the top determinants of performance: size, market risk and value. But, in the almost three decades since that paper, other factors have been added to the list, such as those outlined above.
“According to insights from FTSE Russell, the UK investment analysis provider, most investors are looking at multi-factor approaches in combination, rather than taking an isolated single-factor view,” explains Anthony Palmer, Group Commercial Director at Carrick Wealth.
“This is made easier and more effective in the world of data analytics and data mining, which makes it simpler to deal with the number of factors an investor must consider. This is just one reason why working with a professional advisor or wealth firm is so important, since we strive to marry your individual investment needs to the factors best suited to your investment style, risk profile and your portfolio needs. The truth is, it can be quite daunting to ‘go it alone’.”
Adopting a factor investing approach plays an important role in building a solid investment foundation, which can then be built on and improved by adding in other, more advanced investment factors and investment strategies.