Q&A: What is factor investing?

Q&A: What is factor investing?

by Christopher Doll, Vice President, Product & Business Strategy, PowerShares Canada, Invesco Canada

Factor investing has attracted a lot of attention from investors and media recently, but its roots can be traced back to the 1960s. As innovators in the factor-investing space, we believe in pushing the boundaries of portfolio construction with factor-based methodologies that go beyond traditional indices, allowing investors to target specific risk/return objectives with more precise portfolio-building tools.

We recently hosted Tim Edwards, Senior Director, Index Investment Strategy at S&P Dow Jones Indices, for an in-depth discussion about factor-based investing and the role it can play in a diversified portfolio.

Prior to joining S&P Dow Jones Indices, Tim worked at Barclays Capital, where he had global responsibility for product development of exchange-traded notes across all asset classes, covering commodities, volatility, foreign exchange, fixed income and emerging markets. Tim holds a PhD in mathematics from University College London.

The Q&A below is the first part of our conversation. Stay tuned for a detailed look at combining factors in a portfolio.

Chris: What is factor investing? What are the factors?

Tim: To be a factor, two things in particular need to be true. The first is that it needs to be a characteristic of stocks that explain or drive the differences between returns, or helps explains how certain parts of the market have performed. For example, small or large companies often perform differently, and frequently a company’s size can help explain why they have performed relatively well or poorly. Size is a factor. The second characteristic of a factor is that it is something that can be measured and captured. For example, whether or not a company is going to outperform their earnings estimates would be very useful thing to know, but we can’t really tell for sure which companies will do that. So, this is not a factor. Size, along with dividends, stock volatility and momentum all are examples of factors: they can be measured explicitly for each stock and play a role in distinguishing between the performances of various stocks or market segments.

The measurability of factors means you can build an index or portfolio providing exposure to that factor (small stocks, high dividend stocks, stocks with positive momentum and so on), while the fact that factors explain or drive returns means that those portfolios can be expected to reflect the factor tilts of their constituents. Hence the term “factor investing”, which really means investing in portfolios specifically designed to capture certain factors.

Chris: Factor investing is rooted in decades of research. Can you talk about some of the better-known factors, those that have shown persistence as consistent drivers of returns?

Tim: I’ll start with the factor that has had the greatest academic focus, the low-volatility factor – based on the premise that stocks which demonstrate lower risk tend to outperform. The reason there’s such academic interest around this factor is that the data is very much contrary to the academic preference for risk and returns to rise in tandem. Instead, in markets across the world, lower-risk stocks have historically offered a much better risk/return profile.

Another factor, which is perhaps even more famous in the investing world, is value. The concept of paying $9.00 for $10.00 worth of assets is an attractive investment strategy. And value IS a factor. We look to measure value through concepts such as price versus accounting (book) value, or through other comparisons between the price of a stock and its fundamental characteristics.

Two more that are very commonly looked at include size – small companies tend to outperform large companies – and momentum, which is the concept of identifiable trends within individual equities, relative to each other and to the market.

Those are some of the more well-known factors, but there has certainly been an increasing appreciation of factors in recent years and accordingly, there is plenty of new research being produced on new or more esoteric factors.

Chris: Why have certain factors provided better risk-adjusted returns historically and how is this likely to persist in the future?

Tim: The outperformance of a few factors, I would identify low volatility, value and momentum in particular, has been the source of much academic and practitioner debate. The long-term outperformance from these factors over market cycles is, of course, interesting to academics. The question for academics is, “How can this be possible if the market is efficient?” For investors, the more pertinent question is whether they have the right exposures to these factors, and if the historical pattern of outperformance will continue.

Of course, why this or that factor might or might not be outperforming is specific to the individual factor and time period. But let’s take low volatility for example, to give you an idea.

There are three reasons that are given to explain the outperformance of stocks considered to be less risky. The first is a presumed preference among active managers for higher-risk stocks, which provide them with a strong exposure to the market – more “bang for their buck” – and allow an active manager to achieve a high level of market participation, even when holding some cash on the books. It is speculated that such demand for higher-risk stocks might leave lower-risk stocks more attractively priced for everyone else.

The second is a behavioural argument, referred to as the “preference for lotteries”. This is the idea that investors are willing to overpay for the chance for much higher returns and are less willing to pay for the more mundane chance of getting slightly richer. A preference for lotteries would cause investors to overpay for more volatile stocks – that might make them a fortune – and mean that other, less volatile stocks outperformed in the long term.

The final reason is time horizon, which is something very important to the wealth management community. In the short term, a slightly higher expected return might be worth quite a bit more risk. Over the long term, however, the compounding effect of returns – and the likelihood of losing at least some of the time – can mean that there is a serious advantage to risk management. In that sense, low-volatility indices are just another risk management strategy.

Chris: What has the evolution of indexing meant for investors trying to seek factor returns or capture factor returns?

Tim: In my opinion, what we’ve seen in the indexing space is a democratization of the fundamental secrets of professional portfolio management.

A good few decades ago, offering market-like returns was a highly rewarded activity. In time, managers’ performance began to be increasingly compared to broader market benchmarks. Then those same benchmarks became investible, at a relatively low cost, via the first index funds. Other strategies in the purview of active management eventually followed: value, risk management or momentum strategies became widely available in indices. As time passed, it became increasingly apparent that the core patterns of returns that many funds were offering were systematically replicable through a market exposure and a few select factor tilts. I see it as something of a democratization process, in which these forms of investing are examined, systematized, indexed and eventually made available to investors through index-linked investment products, typically at a much lower cost and with greater transparency.

Chris: In your mind is factor investing a free lunch? Is there a way for investors to know when to rotate between factors to end up with a better result than the market?

Tim: I would caution against a belief that any one of these, or any one combination of these, will deliver persistent constant outperformance. The low-volatility strategy, for example, will tend to underperform in a strongly rising market. The value factor may underperform in different parts of the business cycle. There’s no magic recipe that gives you the perfect solution over every time period, each of these factors will ultimately be affected by the macro environment.

Having said that, there is obviously the opportunity for investors to either diversify their factor exposure or to dial up or dial down their exposure to factors that they either believe have a long-term outperformance characteristic or are more suited to the current environment.

Upcoming

Now that we’ve covered the basics of factor investing, our next installment of this conversation will look into combining factors, correlation between factors and tools that you can use to better study and understand factors within a portfolio.

If you have any comments or questions, you can leave them in the comment box below.

This post was originally published at Invesco Canada Blog

Copyright © Invesco Canada Blog

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