All You Need to Know About Factor Investing
The art and science of investing are constantly evolving. Every investor is unique and has specific financial goals and requirements. Hence, investors need an investment strategy that is customized to their needs.
When you decide to buy a mutual fund, investment experts ask you to assess your risk tolerance levels, the time horizon of investing, and financial goals to choose the right funds for you. However, there are different strategies used by experts to choose investments.
Today, we are going to talk about one such strategy – Factor Investing.
What is Factor Investing?
Factor Investing is a strategy of investing where investments are chosen based on certain factors that can help generate higher returns, increase diversification, and manage the overall risks of the investment portfolio.
While factor investing has been used by experts for a long time, it is only recently that it has started gaining popularity among investors.
There are two broad categories of factors that are used in this investment strategy:
- Macroeconomic Factors – these include broader risks in different asset classes like economic growth, inflation rates, liquidity, etc.
- Style Factors – these include risks specific to the asset class like volatility, momentum, value, etc.
In simpler terms, factor investing leverages the power of consistent drivers of returns.
Common factors used in factor investing
While there are hundreds of factors that you can choose from, here are some of the most commonly-used factors.
Value
When you use value as the factor, you try to find stocks that are being traded at prices lower than their fundamental values. By investing in such stocks, you can earn high returns when they increase in price to match their intrinsic values.
There are many financial ratios that can help you identify undervalued stocks including:
- Price to Earnings Per Share (EPS) or P/E Ratio
- Price to Book Value or P/B Ratio
- Price to Sales or P/S Ratio
- Price Earnings Growth Rate Ratio [PE/Annual EPS Growth Rate]
- Debt to Equity or D/E Ratio
- Debt to Asset or D/A Ratio
- Dividend Payout Ratio, and many more
There are many mutual fund managers that base the fund’s portfolio using the value investing strategy.
If you are planning to get started with Factor Investing and want to invest in a basket of value stocks, then you can consider investing in such funds. Note that, there are various mutual funds that use factor-based investment strategies.
Size of the company
This factor can help investors identify small-cap companies that have the potential to offer better returns than large-cap stocks.
Quality of the company
This factor helps identify stocks of companies that have strong corporate governance, low debt, and consistent returns. Such stocks tend to outperform their peers. You can identify high-quality stocks by using factors like:
- Return on Equity or ROE Ratio
- Earnings Stability
- Dividend growth stability
- Cash flows, and many more
Momentum
This is an important factor as it allows investors to choose stocks that have witnessed strong growth in recent quarters. While the reasons behind the growth may vary, some investors look for stocks that have momentum on their side and invest in them.
Volatility
Some investors believe that stocks with low volatility can earn higher risk-adjusted returns than those with higher volatility. They choose stocks based on the volatility in their prices.
Dividend Yield
This factor can help you identify stocks that have a higher dividend yield than the sector average. Many investors believe that such stocks tend to outperform stocks with lower yields in the long run.
Benefits of adopting a factor investing approach
Here are some benefits of adopting a factor investing strategy for your investments:
Combines Active and Passive investing
Active and Passive investing are investing techniques used by investors and fund managers across the world. In active investing, you choose stocks and mutual funds based on your research and analysis. You monitor your investments and buy/sell them based on their performance. In passive investing, you invest in an index fund or a set of securities where you try to benefit from the growth of the said set.
Factor Investing combines the benefits of active and passive investing. This is because you choose securities based on a factor but also monitor their performance and make changes if needed.
Cost-efficiency
Passive investing is the cheapest way of investing since you do not have to analyse securities to choose the ones that suit your financial requirements. On the other hand, Active Investing is highly expensive since it involves a lot of research and analysis.
Factor Investing is costlier than passive investing but cheaper than active investing. Therefore, you can get better returns than passive investing with controlled risks.
Evidence-based investing
Most active investors have to take an informed guess about the direction the price of a stock can take and invest accordingly. However, with factor investing, the decisions are made based on evidence or metric of the performance of securities based on certain factors. This makes factor investing more evidence-based and reliable as compared to active investing.
Helps reduce volatility
If you create an investment portfolio based on different factors, then it will have low volatility and high diversification. Make sure that the factors you choose have a minimal correlation.