What Is Factor Investing?

Factor investing is an investment strategy that involves choosing securities based on attributes that are associated with higher returns. This type of investing aims to reduce risk that may otherwise be hidden in a portfolio of securities with similar exposure. Proponents of factor investing argue that this strategy allows investors to make better decisions.

Types of Factors

The two main types of factors are 澳洲幸运5官方开奖结果体彩网:macroeconomic factors and style factors. Macroeconomic factors captu💎re broad risks across asset classes. Style factors aim to explain returns and risks within asset classes.

Some common macroeconomic factors include the rate of inflation, GDP growth, and the unemployment rate. Style factors encomp🥀ass growth versus value stocks; market capitalization; and iಌndustry sector.

Understanding Factor Investing

Factor investing is designed to enhance diversification, generate above-markꦫet returns, and manage risk. 

Portfolio 澳洲幸运5官方开奖结果体彩网:diversification has long been a popular safety tactic, but the gains of diversification are lost if the c🐻hosen securities move in lockstep with the broader market. For example, an investor may choose a mixture of stocks and bonds that all decline in value when certain market conditions arise. The good news is factor investing can offset p🌼otential risks by targeting broad, persistent, and long-recognized drivers of returns.

Compared to traditional 澳洲幸运5官方开奖结果体彩网:portfolio allocations like 60% stocks and 40% bonds, factor investing can seem overwhelming and tricky to implement. To simplify their approach, beginners to factor investing can focus on elements such as style (growth vs. value), size (澳洲幸运5官方开奖结果体彩网:large cap vs. 澳洲幸运5官方开奖结果体彩网:small cap), and risk (beta). These attributes a꧃re readily available for most securities and are listed on popular stock research websites.

Foundations of Factor Investing

Value

Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.

Size

Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.

Momentum

Stocks that have outperformed in the past tend to exhibit strong returns going forward. A 澳洲幸运5官方开奖结果体彩网:momentum strategy is grounded in relative returns from three months to a one-year time frame.

Quality

Quality is defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks by using common financial metrics like a return to equity, debt to equity, and earnings variability.

Volatility

Empirical research suggests that stocks with low 澳洲幸运5官方开奖结果体彩网:volatility earn greater risk-adjusted returns than highly volatile assets. Meas𝓡uring standard deviation from a one- to three-year time frame is a common method of capturing beta.

Example: The Fama-French 3-Factor Model

One widely used 澳洲幸运5官方开奖结果体彩网:multi-factor model is the Fama and French three-factor model, which expands on the 澳洲幸运5官方开奖结果体彩网:capital asset pricing model (CAPM). Built by economists Eugene Fama and Kenneth French, the澳洲幸运5官方开奖结果体彩网: Fama and French model utilizes three factors:

• The size of firms
• Book-to-market values
• 澳洲幸运5官方开奖结果体彩网:Excess return on the market

In the model's terminology, the three factors used are SMB (small minus big), HML (high minus low), and the portfolio's return less the risk-free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

The Bottom Line

Factor investing aims to generate above-market returns by enhancing diversification and managing risk. Beginners to factor investing can simplify their strategy by focusing on factors like growth vs. value, market capitalization, and risk (beta).