WHAT IS FACTOR INVESTING?

Factor investing is an investment strategy that involves selecting stocks based on specific characteristics or factors that have been empirically known to drive stock returns. 

These factors include market beta, value, size, momentum, quality, or low volatility. 

By focusing on these factors, investors aim to achieve higher risk adjusted returns compared to traditional market-capitalization-weighted index investing. Factor investing is often implemented through the use of exchange-traded funds (ETFs) or mutual funds that track specific factor-based indexes.

Let’s take a brief look at the history of how factors developed. 

Before researchers discovered factors, they were noticing that diversified portfolios of small cap stocks were outperforming diversified portfolios of large cap stocks. There used to be no explanation for this difference in returns, and it was often attributed as skill of the portfolio manager.

What causes the differences in stock returns?

A simple question that has long been asked by participants in the financial markets is what explains the differences in returns among stocks? 

Taking us back in financial history, for many years, it was commonly thought that market risk, also known as beta, was the only risk factor that investors were compensated for. 

This is an important concept to understand, as in financial markets, not all risk is created equal. Or said another way, not all types of risk mean you get a higher return in investing. 

For example, investors don’t get compensated for taking on idiosyncratic risk¹ or company specific risk, which is the risk that comes with owning individual stocks. This type of risk is unique to the company, such as Elon Musk stepping down as CEO would be devastating for Tesla stock.

The reason investors are not compensated for company specific risk is because investors can eliminate that type of risk through diversification, or buying more stocks. This means that the market doesn’t reward investors with a higher expected return for taking on this type of risk. 

The market only rewards investors for taking on systematic risk, or the market risk² that can’t be diversified away. Every company is exposed to risks of the market, which include inflation, interest rates, recessionary risks. 

However, some companies are more exposed to market risks than others. How exposed companies are to the market risk is shown in their beta. If a company has a beta of 1, meaning it is perceived to be as risky as the market, then if the market goes up/down by 10%, the stock with a beta of 1 is also expected to move by 10%.

A company with a beta of less than 1 means this stock is less sensitive to market risk, and less risky than the market, and will move by less than the market in both up and down movements. 

Usually, companies with a beta of less than one are defensive stocks like utilities, consumer staples, healthcare, and are considered “safer investments” because they aren’t as susceptible to up and down markets, and are often what investors go towards in a market downturn.

A company with a beta of over 1 means the price will be more volatile than the market, and is riskier, which are often tech stocks, or high growth stocks. 

In the 1960s, the capital asset pricing model (CAPM) was developed in an attempt to explain the differences in returns between stocks. This early model suggested that stock returns were directly related to market risk or the beta of a company.

The model suggested that stocks with a low beta (b<1) should have a lower expected return than the market (b=1). Stocks with higher beta (b>1) should reward investors with a greater return for taking on more risk than the market. 

While this sounds good in theory, the problem is this model doesn’t hold up well in the real world. As shown through research and backtests over much of the last few decades, many individual stocks and portfolios performed quite differently from what CAPM predicted.

Particularly, many found that just investing in higher beta stocks did not reward you with higher returns as an investor as the model suggests. This meant that if you wanted to explain why some stocks had higher returns over time, you had to look beyond a stock’s sensitivity to the market’s volatility.

When did factor investing start?

Factor investing has its roots in academic research dating back to the 1960s, but it wasn’t until the 1990s that it began to gain popularity among institutional investors. The concept gained even more traction after the publication of a paper in 1992 by academics Eugene Fama and Kenneth French proposed a three-factor model for explaining stock returns. 

This model was based on the idea that three specific factors – size, value, and market risk – could explain differences in stock returns over time. Their findings showed portfolios of stocks that tilted to include more companies with value and small cap characteristics outperformed the market over the long term. 

Moreover, this finding highlighted the shortcoming in the CAPM model. Specifically, how market risk, or beta, isn’t the only risk factor that explains the differences in returns over time. In fact they found that market beta only explains roughly 67% of the differences in returns between portfolios. But after including size and value in addition to market risk in their model, they were able to explain about 90% of the differences in returns between diversified portfolios. 

Who invented factor investing?

The concept of factor investing has been developed by several academics over the years. However, factor investing is generally attributed to Eugene Fama and Kenneth French, who in the early 1990s proposed their three-factor model for explaining stock returns. The work of Fama and French laid the foundation for subsequent research into factor investing.

Since that finding in 1992, there have been more factors that have been identified beyond the traditional Fama French three-factor model.

In 1997, Mark Carhart introduced “momentum” as another factor and today many academics also recognize momentum as a factor that will lead to higher expected returns over the long run. 

In 2012, Robert Novi Marks introduced “profitability” as another factor that explains returns. This now gave five factors, which together, these factors explained over 95% of the differences in returns between diversified portfolios.

In 2014, Fama and French came up with their own five-factor model which included market risk, size, relative price, profitability, and investment as the five factors that explain the differences in returns, ignoring momentum. They ignored momentum for a few reasons, mostly because momentum requires a high turnover strategy and incurs a lot of costs. 

With this new five-factor model, they found that you can explain almost 100% of the differences in returns between stocks and diversified portfolios based on their sensitivities to these five independent risk factors. This was bad news for many active managers who had claimed to generate “alpha” in portfolios by tilting more towards small cap, and value stocks.  As now, any investor could replicate this strategy on their own and generate the same alpha without paying a manager a high fee.

TYPES OF FACTORS

While there have been hundreds of factors to emerge since the strategy was popularized by Fama and French, not all factors are created equal. Larry Swedroe came on the Millennial investing podcast on episode MI238 and talked about the 5 criteria factors need to meet in order for him to invest in them. The factors that meet these criteria are: market beta, size, value, momentum, profitability, quality factor.

FACTOR INVESTING STRATEGIES

Factor investing strategies have gained significant attention in recent years among investors looking to enhance their portfolio returns. These strategies have become popular as more options have become available to investors through low-cost, ETF products, making this strategy very easy to implement without the need to hire a manager or pick stocks yourself. 

The approach involves targeting specific characteristics or factors, such as value, size, profitability, momentum, or low volatility, that have historically delivered excess returns over the broader market. In this section, we will explore various factor investing strategies and their potential benefits and risks for investors. We will also examine some of the popular factor-based investment vehicles, such as exchange-traded funds (ETFs), and how they can be used to implement factor strategies in a portfolio.

Quality Factor Investing

The quality factor in investing emphasizes the importance of investing in companies with strong financial fundamentals, such as high margins, low financial and operating leverage, stable earnings, high asset turnover, consistent growth and low stock specific risk. This factor suggests that companies with these characteristics are more likely to generate sustainable long-term returns for investors. Quality companies are often seen as less risky investments because they are less likely to experience sudden drops in earnings or face financial distress during economic downturns.

Companies with these attributes historically have provided higher returns, especially in down markets. Over the period from 1927 through 2015, the quality premium has been very persistent across time periods.

Investors who focus on the quality factor often seek out companies that have a proven track record of success and a competitive advantage in their industry. They may also look for companies with strong management teams and a clear strategy for growth.

However, it’s important to note that high-quality companies may also be more expensive to invest in, and there is no guarantee that they will continue to perform well in the future. 

Because of this, some investors who implement this factor screen for additional factors such as value to ensure they are not overpaying for the company. Investing in stocks with quality and value factors are characteristics that Warren Buffett has long used in his investment strategy, well before factors became popularized by academics.

Momentum Factor Investing 

The “momentum” factor in investing refers to the tendency of securities that have performed well in the recent past to continue to perform well in the near future. Momentum investors believe that the market tends to underreact to positive news and overreact to negative news, leading to trends that persist for a period of time. Therefore, they seek to invest in securities that have shown positive momentum in their price movements, expecting that these securities will continue to perform well in the short term. Over the period from 1927 through 2015, momentum premium has been very persistent across time periods³.

One way for investors to gain exposure to the momentum factor is through buying individual securities that have recently performed well. The research suggests that investors should consider a three month to one-year time frame when examining past performance to capture the momentum premium. 

Another option is exchange-traded funds (ETFs) or mutual funds that track indices of securities with strong momentum. However, despite the robust evidence that a momentum premium exists, in practice many funds have not lived up to the expectations as momentum is a high turnover strategy that results in excessive transaction costs. Because of this, many momentum ETFs have failed to deliver on their expectation of higher returns. 

Value Factor Investing

The value factor is one of the most well known factor premiums. This factor shows that cheaper⁴ companies, otherwise known as value companies, tend to outperform growth companies, or more expensive companies in the long run. Although value has gone through long periods of underperformance, particularly in this last decade, over a 10 year period, the odds of outperformance of this strategy is 86%. This means this strategy may be more suitable for long-term investors who are able to stick to the strategy despite some periods of underperformance.

The value premium has both behavioral and risk based explanations as to why it exists. The risk-based argument explains that the reason value stocks outperform growth stocks over time is because cheaper (or value) companies are riskier than more expensive companies. The riskier company should have a higher discount rate than the more stable company and therefore reduces the current price. 

The behavioral argument as to why the value premium exists is related to the irrational exuberance in the market where growth stocks tend to be more popular and therefore investors tend to favor them, and bid up the price beyond its intrinsic value. 

Small Cap Factor Investing

The size factor was one of the first factors discovered by Fama and French in 1992 which showed that small cap stocks tend to beat large cap stocks over long periods of time. The size premium has been persistent over time, and the chances of success with this strategy increase as the investment horizon increases. Over a 10 year period, the odds of outperformance are 77% and in 20 years increases to 86%.

One important nuance with investing in small cap stocks is to make sure you are controlling for quality (which is a factor discussed above). As many small cap stocks fail, may go bankrupt, it is important to only invest in those for which quality is controlled for, or ones that have shown a history of profitability and financial stability. Some indexes do this better than others. For example, the S&P 600 index implements a rules based strategy which requires the companies to make money before entering into the index, this effectively adds a quality filter to ensure that small stocks that aren’t money aren’t entering the index. 

Multi Factor Investing

Additionally, there are strategies that provide a multifactor approach that involve combining certain factors with positive correlation to achieve higher expected returns, or negative correlation to achieve greater diversification.

Below is a table of factors and their respective correlations with each other. Understanding these relationships can be useful for investors who wish to increase their returns or their diversification by implementing multi factor strategies.

As example, small cap and value stocks are positively correlated, so when combined, they have a higher expected return. Many funds are available that seek to capture these multifactor premiums. 

Factor Investing ETF 

With hundreds of different factor based ETFs trading on the US market today, investors may be left wondering which ones are best. The first thing I want to point out is that not all factor ETFs are created equal, and only a select few may be worthy of a spot in your investment portfolio. Picking factor investing ETFs requires due diligence, just like with selecting individual stocks. 

Unlike total stock market ETFs, just choosing the lowest cost factor ETF may not lead to the best choice for a factor ETF. This is because the lowest cost factor ETF may not be very good at capturing the premium it is after, leaving you better off just investing in a total stock market ETF. 

The point of factor investing is that it should generate higher returns than what you could get by just investing in the total stock market, a fund like VTI, XUU for example. Unfortunately, many factor ETFs underperform total stock market ETFs because:

1. Some factor ETFs may have much higher costs compared to total market ETFs from both higher expense ratios and higher turnover costs, which don’t end up making up for it in terms of higher returns. 
2. Some factor strategies are harder to implement and profit from when packaged as an ETF product (such as momentum which is a very high turnover strategy). 
3. Some factor ETFs are implemented inefficiently and do a poor job of actually capturing the premium they are seeking to target. As an example for small cap factor ETFs, while Vanguard’s VB is the lowest cost of them all, it does a poor job of implementation and getting exposure to the small cap stocks it is targeting. We can see this because the median market cap of this fund is $5.6B which is generally considered mid cap stocks. This means that while it is marketed as a small cap factor ETF, the chances that you will get much “small cap” premium from this fund are slim. 

To further this example, when comparing the performance of VB vs VTI, from January 2005-February 2023, VB has underperformed VTI. As well as it has underperformed VTI on a 1,3,5,7,10,15 year basis. This means that you would be better off investing in the total stock market index versus paying a premium to invest in this factor ETF.

An easy way to think about it is that the factor ETF should be expected to beat the ~ 9%  CAGR that the market has historically given you. 

An example of two funds that are implemented well and have historically achieved all the necessary criteria are: 

1. iShares Core S&P 600 Small Cap ETF (IJR)

This fund is a single factor strategy, targeting small cap stocks, and has an expected return of 12.38% 

Since January 2002, this fund has achieved a CAGR of 9.55%, turning an initial $10,000 investment into $68,964. This beat an investment in VTI by over 1%, which amounted to $13,363 extra in your pocket.

This ETF also outperformed Vanguard’s Total Stock Market ETF on all 1 year, 3 year, 5 year, 7 years, 10 year and 15 year rolling time periods.

2. iShares Core S&P Small Cap 600 Value ETF (IJS)

This fund is a multi factor strategy, targeting both small cap and value stocks. This ETF has an expected return of 12.81%. 

Since January 2002, this fund has achieved a CAGR of 9.13%, turning an initial $10,000 investment into $63,566. Once again, this ETF beat investing in the total market (VTI) by over .69%, which meant earning an additional $7,965 over the time period than what you could have earned by just investing in the total stock market index.

However, value strategies have gone through periods of underperformance. As a result, this ETF slightly underperformed VTI during some of the rolling periods. This ETF has a higher risk/reward than the single factor ETF (IJR), with a higher expected return means higher probability of some years of underperformance and may be more suitable for investors with a higher tolerance to risk and long time horizon. 

Today I mentioned two passively managed Factor ETFs that I like as examples of how one might implement this strategy. 

There are also actively managed factor ETFs available through providers like Avantis and Dimensional. The key difference between actively managed and passively managed factor ETFs is the level of human intervention in the investment decision-making process. Actively managed factor ETFs are managed by an investment professional who actively select and adjust the underlying securities.  In contrast, passively managed factor ETFs are rules based, and track an underlying index that is designed to capture a specific factor. This means that the portfolio holdings and weightings are predetermined by the index methodology, not a person such as with the active strategies. 

Factor Investing in the Corporate Bond Market

Factor investing in the bond market involves the use of factor models to explain the returns of fixed-income portfolios. The idea is to use these models to identify and quantify the impact of various factors, such as term, default, and style premiums like value, momentum, carry, and defensive, on bond returns. In the past, factor investing was more common in the equity market, but new research suggests that bond investors can benefit from using these models too.

A 2009 study by Marlena Lee found that active bond funds underperform their benchmarks by the amount of their fees. She also found no evidence of winner persistence in net returns beyond random expectation, meaning that it was difficult to separate skill from luck. However, recent research by Jordan Brooks, Diogo Palhares, and Scott Richardson of AQR Capital Management suggests that style-based investing in fixed income can enhance returns in various bond markets.

More recently, Peter Mladina and Steven Germani conducted a study to evaluate the efficiency of bond markets and the impact of various risk factors on bond portfolio returns. They found that the default factor is a significant risk factor in the bond market and that factor-adjusted alphas could be used to evaluate manager performance. They also found that term and default factors, as well as the style premiums identified by Brooks, Palhares, and Richardson, helped explain returns in bond portfolios.

WHY INVEST IN FACTORS?

There are several reasons why an investor might choose to use a factor-based strategy. First, factor-based investing can potentially enhance returns by providing exposure to specific factors that have been shown to outperform the broader market over the long term. The underlying idea is that by targeting these factors, investors can earn a premium for bearing certain risks that are not captured by traditional market indexes. More importantly, it doesn’t require you to pick stocks, market time, or spend time researching companies to generate alpha. 

One of the other key benefits of factor investing is diversification. Factor-based strategies can be used to manage risk by targeting factors that have low or negative correlations with each other⁵, which provides diversification benefits. By breaking down a portfolio into specific factors, investors can potentially reduce their exposure to certain risks, such as concentration risk or sector risk. 

Additionally, factor investing has become more accessible to retail investors in recent years, thanks to the proliferation of factor-based exchange-traded funds (ETFs) that allow investors to access these strategies at a lower cost and with greater liquidity than traditional actively managed funds.

THE DIFFERENCE BETWEEN FACTOR INVESTING AND SMART BETA

Smart beta and factor investing are both strategies aimed at providing investors with better returns than traditional market-cap-weighted indexes, but they have some key differences. Market cap-weighted indexes have inherent flaws, including a concentration of the largest companies and any that happen to be overvalued, which are most likely to underperform the broad market over long periods. Smart beta and factor investing aim to address these flaws by capturing factor premiums that have been known for decades. 

Factor investing involves creating portfolios that target specific attributes that have been empirically shown to drive higher expected returns over time, such as small cap stocks, value stocks, quality, low volatility, or momentum. Factor investing can be implemented in a number of different ways. For example, factor investing can be implemented using a single factor approach such as only buying value stocks to capture the “value premium,” or a multi factor approach, such as investing in stocks that have small cap and value characteristics. 

Smart beta, on the other hand, refers to investment strategies that deviate from traditional market cap-weighted indexes and instead use a fundamental weighted, equal weighted indexes or low volatility strategies to beat market cap weighted indexes. Indirectly, smart beta strategies provide more exposure to certain factors, but do not directly target them like a traditional factor strategy.

For example, a smart beta strategy that uses a fundamental weighted index works by trimming positions in companies whose price is rising but their fundamental value isn’t changing, and buying companies whose prices are falling but their fundamentals remain the same. By breaking the link with price, it forces the index to rebalance against the market’s most extreme bets. Since fundamental weighting has a value tilt as it’s always buying out of favor companies, this strategy is essentially targeting the “value factor” and gives you added weight to companies with low price-to-book ratios, higher dividend yields or other traditional value factors. Equal-weighted indexes give added influence to smaller firms.

The key difference is that in factor investing strategies, factors are directly targeted, while in smart beta strategies, the rules-based approach indirectly targets certain factors, which is why it’s called “smart beta” because it deviates from market capitalization weighted indexes.

THE DIFFERENCE BETWEEN FACTOR INVESTING AND TRADITIONAL INVESTING

Traditional investing typically involves buying and holding a diversified portfolio of stocks, often based on market capitalization or sector allocation. In contrast, factor investing focuses on identifying and capturing specific factors or characteristics that are expected to generate excess returns. 

By targeting factors such as size, value, momentum, or quality, factor investing aims to outperform the broader market over the long term.This approach can involve tilting towards certain stocks or sectors that exhibit desired factor characteristics, or investing in factor-based indexes or funds.

THE RISKS ASSOCIATED WITH FACTOR INVESTING

While factor investing can potentially enhance returns, it is not without risks. One of the main risks is the potential for factor premiums to disappear or go through long periods of underperformance as seen with the value factor premium for much of the last decade. 

Additionally, one of the explanations behind why factor investing leads to higher expected returns is because companies with these certain characteristics are riskier, which is why they are expected to generate higher returns over time. This means that a factor investing strategy is a higher risk, higher (expected) reward strategy, so it may not be suitable for an investor who doesn’t have the ability or willingness to take on a higher, albeit, compensated risk in their portfolio.

MYTHS ASSOCIATED WITH FACTOR-BASED INVESTING

There are several myths associated with factor-based investing. One common myth is that factor investing is a form of market timing, which is difficult to execute successfully. However, factor investing is based on long-term exposure to specific factors and not short-term market timing. 

Another myth is that factor investing only works in certain market conditions, but research has shown that factors can outperform over the long term regardless of market conditions. Finally, some investors believe that factor-based strategies are too complex or expensive, but there are now many low-cost factor-based funds and ETFs available to retail investors.

FREQUENTLY ASKED QUESTIONS ABOUT FACTOR INVESTING

¹ Also known as unsystematic risk.
² Also known as systematic risk.
³ In a 2013 study by Cliff Assness, Tobias Moskowitz and Lasse Pedersen titled “Value and Momentum everywhere” they found that there was a positive momentum premium in every class (stocks, equity future indexes, bonds, currencies, and commodity futures) as well as across eight different markets (US, UK, continental Europe), and was statistically significant everywhere but Japan. Kenneth French and Eugene Fama also found that momentum is stronger for small stocks, especially microcaps.
⁴ While there are many different metrics for determining value, book-to-market used to be the most common.
⁵ For example, value and momentum factors, or size and profitability are negatively correlated factors and therefore when combined, offer greater diversification benefits.