What is Factor Investing?

Financial Autonomy - Blog
What is Factor Investing?

You’ve almost certainly heard of index investing, also sometimes called passive investing. Here investment portfolios are constructed to replicate I given a market. The weighting given to each individual stock is determined by the size of each company, its market capitalisation. So for instance in the Australian market, the largest allocation would be to BHP, then Commonwealth Bank, CSL, etc.

The main alternative to index or passive investment is active investment. Here fund managers deploy various strategies in an effort to outperform the market average.

Factor investing sits in between these two approaches. It’s been around for a long time, with mixed results. ETF offerings adopting a factor investing methodology are expanding in the Australian market, so this is an investment approach that you are likely to hear more about.

Let’s get you up to speed.

What are the common factors used in factor investing?

Factors are elements of an investment that represent a specific risk. Some factors are expected to produce a reward for the investor, whilst others go unrewarded. The aim when applying a factor based investment approach is to identify those factors where the historical evidence indicates investors have been given an additional reward over and above that of a neutral portfolio, and where there’s an expectation that this additional reward will persist in the future.

The most commonly used investment factors are:

  • Value
  • Size
  • Momentum
  • Quality

A fund employing a factor based approach would use one or a combination of these factors to adjust the allocation of their portfolio away from the standard market capitalisation based index. Portfolios therefore have a bias or tilt towards one of these factors.

The Value factor is perhaps the most well known and applied. Here the portfolio is tilted towards stocks where their price relative to their earnings is below the market average. Historical data has suggested that investors who adopt a value bias achieve superior long term returns. The challenge with this approach is that a value bias can underperform the broader market for a very long time. Value based portfolios will typically be underweight growth stocks. A stock like NVIDIA for example, which is up 250% in the last 12 months, would be highly unlikely to have a significant weighting within a value biased portfolio. This is a problem when markets are rewarding growth, which they very frequently do. The investor holding a value portfolio therefore needs to exhibit extreme patience, something research suggests we are all pretty poor at doing.

The Size factor is working off the evidence from the United States that over the long term small cap stocks tend to outperform large cap stocks. Like all the factors, this has been established through research on historical price movements. However also like most of these factors it’s not difficult to construct a logical explanation for why this factor should work. In the case of a size bias, it is the case that all large companies were small companies once. To make it to large company status, they’ve grown strongly. As an investor, participating in this strong growth phase provides clear rewards. Holding a portfolio with a bias towards small caps would therefore appear to make sense.

There seem to be two challenges with this particular factor though. Firstly, the historical data doesn’t bear out that adopting this factor is successful in the Australian market. I haven’t come across anyone with a definitive theory as to why that should be, but my guess would be that the size of our market is such that any company outside the top ten on the ASX is the equivalent of a small cap in the United States. Companies defined as small cap here in Australia would be mere fleas in the United States. The sweet spot for investors is perhaps when companies are a bit larger and more established than this very small scale.

It may also be that many of our small caps are minerals explorers, and most of them don’t go well for outside investors.

A Momentum approach seeks to recognise that stocks tend to follow a trend either up or down. A trend that can persist for months and perhaps years. Portfolios applying a momentum factor will look to identify those stocks with upward momentum and build exposure. Similarly, stocks on a downward trajectory will be underweighted relative to a market cap index.

You could imagine that value and momentum portfolios would look very different. A value biased portfolio is trying to find the unloved stocks, patiently waiting for sentiment to turn, whereas a momentum biased portfolio is deliberately jumping on the bandwagon of those stocks on a run.

Our fourth factor is Quality. A portfolio built applying a quality factor will have a bias towards those stocks with low levels of debt, consistent revenue, and consistent dividends. Different fund managers will arrive at their assessment of quality in different ways, however these characteristics are likely at the heart of all of them.

This one seems a bit of a no brainer. Would any of us really want to invest in companies that aren’t considered of good quality? In practice though the challenge is that typically the companies that score well in these quality measures are stable and well established businesses whose growth capacity is frequently limited. Examples in the Australian market for instance might be our four big banks. Probably good, safe, secure, investments that will give you a reliable dividend. But they are not Tesla.

 

I should make clear that these four factors are certainly not the only factors that investment managers might apply, merely the most common. Factors such as liquidity and volatility are also not uncommon.

 

Factor based investing then is a way to construct portfolios which vary from the standard indexes by adding different filters or criteria that lead to biases in one direction or the other. Each of the factors has arisen out of some sort of inherent logic. Academics have then trawled through the historic data in an effort to establish whether there is any validity to the gut feel.

Standard market capitalization based indexes aren’t perfect. In a small market like Australia, you do end up quite concentrated in a relatively few industries. Even in the much larger U.S. market, the mega caps of Apple, Microsoft, Alphabet and Amazon end up dominating your portfolio.

Factor approaches may well offer a solution to these shortfalls. Some factor based ETFs in the United States have an impressive long term track record. The challenge is whether that past performance will be replicated in the future, and also whether strategies that were successful in the United States will necessarily translate to our local Australian market.

Back to All News