Factor Investing

Factor investing is a strategy for portfolio asset allocation that moves away from the traditional market-cap weighted approach towards alternative weightings (based on factors) with the goal of improving investment performance and portfolio diversification.  In this framework, the portfolio building blocks are factors, rather than asset classes. Factors can be viewed as characteristics of stocks that are used to explain their underlying risk and price return performance. The theory behind factor investing is that the performance of any portfolio of stocks is often related to a single or small number of factors, so the investing process can be improved by isolating and focusing on those very same factors. Single factor approaches tend to outperform the more traditional capitalization-weighted benchmarks over the long term. The strategy is simple enough….as we build a portfolio, we overweight stocks that rank high on a certain factor and underweight stocks that rank low on that factor.

We view stock factors as either defensive factors (low volatility, dividend and quality) or cyclical factors (momentum, value and size).  Low volatility stocks show lower historical price fluctuations and are often associated with higher risk-adjusted returns. Dividend stocks not only provide some income during periods of declining markets, but they also tend to smooth out portfolio volatility as they often have a beta (β) under 1.0. A quality factor is based on the financial strength of a company using metrics like return-on-equity, earnings stability, balance sheet strength and financial leverage. Momentum stocks have performed well recently and often tend to continue outperforming in the near term. This positive momentum is often aided by the perception that investors sometimes initially underreact to improving fundamentals and company trends. Value investing targets companies with lower-than-average growth rates for sales and earnings and lower-than-average price-to-earnings (P/E) and price-to-book (P/B) ratios. With value stocks we are looking for a bargain – stocks that are inexpensive relative to their fundamental value. When a portfolio is based on a size factor, all companies selected are equally weighted, in contrast to the more traditional method of market cap (large, medium and small) weighting. Smaller companies have historically generated higher returns but also show higher return volatility. Factors can be used to construct a variety of asset allocation models ranging from conservative (low volatility, dividend and quality) to more aggressive (momentum, value and size).

While factor analysis offers great insight to investors, it is not without its challenges. For example, there is no universal agreement on what factors are most important in predicting stock price performance. The right factor to consider depends on what questions you are trying to answer. Once factors that best drive risk and return are identified, exposures can be measured on an ongoing basis to ensure a portfolio is best constructed to take advantage of those factors. Over time different factors tend to outperform in different market environments.   While returns for the most widely used factors (low volatility, dividend, quality, momentum, value and size) have proven to be consistent over time, it is noted that those returns show a wide degree of variation – from best performing (momentum) to worst performing (low volatility). In addition, while single factor strategies have often outperformed the broader market, there have been periods in which they underperform. Factor performance tends to be cyclical, and most factor returns are not highly correlated, a condition with suggests that combining multiple or blended factor (a multi-factor approach) strategies might improve portfolio diversification. The cyclicality of factor returns may suggest to investors an opportunity to time their exposures – beware, however, as factor timing can be far more difficult than market timing!