How-Factor-Investing-can-Help-Build-Stronger-and-More-Effective-portfolios

1. How Factor Investing can Help Build Stronger and More Effective portfolios

2. How Factor Investing can Help Build Stronger and More Effective portfolios A Quick Overview of Factor Investing n At the core of factor investment strategies are factors such as momentum, value, low volatility, size, and quality. When used in tandem, these factors can help protect portfolios from downturns and increase returns. n Factor investors can benefit greatly by employing a variety of factor strategies. Since factor returns don't always correlate with one another, targeting multiple factors can help boost portfolio returns. n Certain investment goals can be met with factor-based strategies, including mitigating investment risks and increasing portfolios returns. n Many investors have turned their attention to factor investing in the last few years due in parts to its importance in smart beta investment strategies and its growing popularity among institutional and private investors. These strategies have seen more than $240 billion in capital inflows in the last four years. This article provides a general overview of factor investing, its history, theory, performance, and the potential benefits of employing factor-based investment techniques. We highlight how factor-based strategies can play valuable roles in portfolio constructions and how investors can use factor investing as a hedge against volatility and market uncertainty. 01 How Factor Investing can Help Build Stronger and More Effective portfolios page.

3. The History of Factor Investing Factor investing, also known as smart beta or strategic beta, got its start in the 60s with the capital asset pricing model, or CAPM. This model, developed by Harry Markowitz, Merton Miller and William Sharpe, asserts that stock returns are driven by a single factor – volatility of a stock compared to that of the overall market – called beta. In other words, a single stock's expected performance is driven by how much that stock rises or falls compared to the overall market. When market factors were taken out the equation, CAPM concludes that other things that can explain stocks' gains or losses are company specific, for instance, earnings that beat projections, worse than expected losses, product launches, leadership reshuffling, accounting malpractice, etc. Beta Gets Better In the following decades, experts, analysts, and academics introduced other theories that they claim are responsible for stocks rates of returns. APT (arbitrage pricing theory), put forward by Stephen Ross in the 1970s, states that a multi-factor approach is a better model and a better explanation of stock returns and behavior, but didn't define the factors. In 1992, Eugene Fama and Kenneth French introduced their 3-factor model. This model suggested that in addition to CAPM's beta, a company's valuation and its size are also big contributors to its stock price. Since then, dozens of other factors have been studied, and a few, such as momentum and quality have become widely used factors in factor investment strategies. While some factors have shown to produce above-average returns, other factors can help explain the risk involved in stocks. An example of this is CAPM's beta, which almost never delivers excess returns; instead, since it measures the sensitivity of stocks to broader market movement it may be best classified as a risk factor. Thus, market beta alone is not enough to produce long term returns. Investors looking to beat the market or generate excess returns should consider exposure to other factors that have track records of outperforming the markets. Many investment managers have benefited greatly by incorporating these factors into their portfolio. Factors are also widely used by fundamental investors, either as a way to find new stock or investment ideas or to measure intended or unintended exposures in their portfolios. 02 How Factor Investing can Help Build Stronger and More Effective portfolios page.

4. How can Investors Take Advantage of Factors? Most factor-based strategies are based on systematic analysis, weighting, selecting, and portfolios rebalancing to bolster stocks with known characteristics to enhance investment returns over time. While most factors are relatively easy for investors to calculate, using low-cost funds is generally the easiest way to invest. The increased interest in factor investing has led to the creation of dozens of funds targeting various factors. Generally, investors seek exposure to factors by employing these quantitative, semi-actively managed funds or ETFs that are designed to track certain markets and indexes. By doing this, specific factors can be targeted without decreasing portfolio diversification. Five Common Factors The factors discussed below are widely utilized by investors as key exposures in investment portfolios; they are also identified by academics as important elements that contribute greatly to stock price returns. Size Research by Eugene Fama and Kenneth French showed that there are huge benefits to investing in smaller-cap stocks due in part to their riskier nature. Studies have shown that smaller companies are more prone to bankruptcy, thus investors expect to earn excess returns to offset bad investments. Despite the higher failure rate, small-cap stocks have been shown to outperform large-cap stocks over time. Investing in small- cap stocks or ETFs is a great way to diversify and enhance investment returns, but it's also important to keep in mind the risks that come with investing in a more volatile class of stocks and the impact that can have on the portfolio if markets fall. 03 How Factor Investing can Help Build Stronger and More Effective portfolios page.

5. Value Value is another factor introduced with the Fama French 3 Factor Model, which posited that low-cost stocks should do better than expensive stocks over time. Value investing was widely researched by experts dating back many decades. In the 1940s, Benjamin Graham told investors that the best way to maximize profits is to buy stocks below their intrinsic value. Graham suggested that buying expensive stocks with expectations of high returns is prone to error while investing in cheaper stocks that can outperform the market provides more upside opportunities. The key takeaway from Graham's idea and the research of Fama and French is that value investing works for investors because over time stocks tend to follow earnings. Studies have shown that investors are more optimistic about expensive stocks with higher- projected earnings growth and less enthusiastic about cheap, low yield stocks. When cheap stocks post higher than expected earnings, they can outperform the more expensive stocks as a result of increased optimism in the market about their growth potential. Other research by Fama and French also suggests that value investing tend to generate great value over time. One of their studies indicated that stocks with high book value to market price ratios always beat stocks with lower ratios. Indexes and other market instruments still place importance on that ratio, and gaining exposure to this valuation factor can go a long way towards enhancing investment portfolios. And yet investors have many different ways of defining value. For instance, investors often take a look at earnings, cash flows, or sales records to determine whether or not a stock is cheap or expensive, and the results seem to vary based on the metrics used. The fact is that using a single-factor definition for value may hurt investment returns. Thus the multi-factor approach to stock picking is more preferred due to its long-term and diversification benefits. 04 How Factor Investing can Help Build Stronger and More Effective portfolios page.

6. Momentum Momentum investing is akin to what many technical analysts do to gauge the mood of the market -study price trends to determine future returns. Momentum was first identified in 1993 in a study published by Sheridan Titman and Narasimhan Jegadeesh in which they showed that stocks that have done well in the medium term are more likely to continue to do well and stocks that lagged will likely continue on that path. Why momentum investing works has been the subject of many debates, but many researchers have argued that investors tend to be less enthusiastic initially about improving fundamentals. It is only when stocks are outperforming, often due to a series of better than expected financial reports, that investors start paying attention. As investors start buying, the stock price gets pushed up, leading to strong medium- term returns. This can continue with the continued expectation from investors of strong earnings reports. Market conditions or internal issues such as lower than expected earnings eventually put an end to the stock price growth and the momentum ceases. One of the best ways to measure momentum is to analyze stock prices within the last two to twelve months. This strategy has proven to work and can help investors beat the broader market. Quality Many investors look to invest in high-quality companies, but evidence validating this approach to investing has only been recently acknowledged, the reason being that it's difficult to define quality or what constitutes quality. For instance, studies have shown that companies with high growth rates, higher earning quality or lower interest rates tend to outperform the broader market over time. Experts have argued that higher earnings, stable income sources and cash flows, and little to no leverage are all factors that make for a quality company because a company with superior earnings and profits must be doing something better than its competitors, thus giving it a significant competitive advantage. Put simply, the idea is that a company with stronger profits, robust balance sheets and healthy cash flows will almost always outperform. 05 How Factor Investing can Help Build Stronger and More Effective portfolios page.

7. Low Volatility Contrary to the “high risk, high return” mantra of stock investing, a lot of recent research suggests that low-volatility portfolios are generally more likely to outperform the broader market in the long term. This has led to the creation number of funds and ETFs that focus on the low volatility factor. There is considerable debate, though, about where this anomaly comes from, with some experts arguing that this factor works due to the size anomaly or industry biases associated with some stocks, and not because those stocks are less prone to volatility. Generally, a strong factor should be able to outperform regardless of sector biases or size, but even though it's not clear that low volatility investing can outperform the broader market on its own, the strategy can work well for investors. Combined with other factors, it can reduce portfolio risk and increase risk-adjusted returns. Care must be taken to ensure that diversification isn't affected with a focus on this strategy. By definition, market movements tend to have less effect on low volatility portfolios, so this approach works particularly well when markets are in decline and volatility is on the rise. 06 How Factor Investing can Help Build Stronger and More Effective portfolios page.

8. How Change in the Economy Affects Factor Performance The factors discussed above can be a great way to enhance a portfolio's performance. However, no one single factor is sufficient to sustain growth over the long term as factor returns are cyclical. For example, small-caps tend to perform poorly in some economic environments, as was the case during the tech bubble of the 1990s and the Great Recession of 2008. Values stocks were also hit hard by the tech bubble but earned their way back in the ensuing years. Rapid changes in markets can be especially damaging to momentum strategies, for example, in early 2000 after the collapse of many tech companies, and in early 2009 during the recovery from the Great Recession. Quality portfolios tend to weaken during bear market rallies when cheap stocks lead the rebound following economic downturns, as was the case in 2003. Lastly, low- volatility stocks typically lag during market recovery after a bear market – as they did in 2009. These swings in performances can force investors to make impulsive decisions or cause them to sell and miss out on market rebounds. One of the good things about factor investing is that factors react differently to the same market event. They are propelled by different market movements, and thus tend to produce favorable outcomes at different times. The cyclical nature of factor returns may force some investors to try to time their exposures. And while factor strategies can allow investors to gain the right exposure in any market conditions, effective factor timing, even with the right factor strategies can be a challenge. Thus, diversifying and using multiple factor strategies may be the most prudent approach for the long-term success of a portfolio. 07 How Factor Investing can Help Build Stronger and More Effective portfolios page.

9. The Implication of Factor Exposures for Investors Factor-based investment strategies applied to a portfolio are an invaluable way of achieving sustainable, long-term risk-adjusted returns. However, it's also important to note that factor strategies can take unanticipated turns and no one single factor is sufficient to consistently outperform the market. Many factor based strategies provide for different needs. For example, some strategies provide exposure to multiple factors in one investment vehicle, while others provide exposure to the unique characteristics of stocks and are designed to address the needs of individual investors. The marketplace for factor-investing is crowded and it can be difficult to pinpoint the right investment vehicle with just about the right factor exposures. Factor strategies vary widely in how they are designed and implemented, and thus will yield different results even within the same investment vehicle. In addition, investing in stocks based on unproven factor strategies may lead to unintended portfolio exposures such as too many small-cap stocks or a heavy tilt towards a particular sector. While there's no one-size-fits-all approach to factor investing, with careful planning, investors can benefit greatly from these investment tools, for researchers have shown that these tools can be instrumental in not just building robust portfolios but also ensuring long term profitability of the investments. 08 How Factor Investing can Help Build Stronger and More Effective portfolios page.

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