Stock markets all over the world consist of many types of asset classes and a large number of individual securities. Such an incredible amount of variety makes it difficult to understand and shortlist what matters for your portfolio. A lot of free stock market courses are available online that can help you with this problem. One of the most important aspects of any stock market course online is understanding a few important drivers that can help explain returns across asset classes. These “factors” are broad, persistent drivers of return that are very important for helping investors create a set of goals ranging from generating returns, reducing risk, to improving diversification. There was a time when factors were only available for the use of professional investors and fund managers. They have used them for decades to do their job of managing portfolios. However, with the rise in technology and an ever ballooning ocean of data, investors can gain access to factors with ease.
Factors are crucial building blocks of investing. You can not but a balanced portfolio together unless you have an understanding of Factors. Similarly, knowing the factors that drive returns in your portfolio can help you to choose the right mix of assets and strategies for your needs. In this post, we will introduce you to the interesting and highly effective world of factor investing. We will cover the basics and go through the common terms associated with the world of factor investing. We will conclude with clear answers to some frequently asked questions about factor investing.
What is Factor Investing?
Factor investing is a strategy that involves selecting securities based on attributes that are linked with higher returns. The main types of factors that drive the returns of stocks and bonds: macroeconomic factors and style factors. Macroeconomic factors deal with a broad range of risks across different asset classes while style factors deal with the returns within asset classes. Some of the common macroeconomic factors are inflation rate, GDP growth, and the unemployment rate. Some common microeconomic factors are a company’s credit, its share liquidity, and stock price volatility. Some common style factors include growth versus value stocks, market capitalization, and the industry sector.
What is portfolio rebalancing and why is it important?
One of the most important traits of a successful investor is the ability to rebalance the portfolio periodically. Rebalancing your portfolio means adjusting your holdings. What that means is buying and selling certain stocks, funds, or other securities in order to retain your established asset allocation. Let’s illustrate that with an example. Let’s assume that your asset allocation consists of 40 percent bonds and 60 percent stocks. For example, let’s say your asset allocation is 60 percent stocks and 40 percent bonds. If the stock prices go up for some significant amount of time, your portfolio’s allocation to stocks might go up to 70 percent. Now, you will need to sell some stocks in order to get back to your desired level of portfolio allocation. It is very crucial for you to maintain your asset allocation since it maintains your risk tolerance at a very comfortable level. Most investors should be fine by just rebalancing their portfolio twice a year and ensuring that their asset allocation stays the way they wanted. Mark the dates in your calendar to ensure that you rebalance your portfolio on those days. This is a great way to remember to carry your rebalancing out.
Here are three reasons why you should rebalance your portfolio:
- Rebalancing forces you to take profits from investments that have run up and put money in things that have merit but haven’t gone up. When one part of your portfolio goes up, you might be overcome by greed and feel like putting more money in it. You must remember to fight against that urge. The best step forward is to draw the profits periodically out of your portfolio from time to time.
- Rebalancing gives you the opportunity to review all of the mutual funds in your portfolio. If a fund you own witnesses a 10 percent increase, you might concentrate too much of your money on that particular fund. What you should do instead is take the profits and buy a second strong fund in the same asset class.
- Rebalancing smoothens investment returns. All asset classes go through cycles. Professional investors will pile into tech stocks or love anything related to gold. But they keep moving on to the next best thing from time to time as that’s the only way to get smooth and consistent returns.
Introduction to factors
Factors have historically been identified as critical drivers of portfolio risk and return and can now be used to better inform the investment process. Factors may help investors meet their objectives such as reducing risk, increasing returns, and increasing diversification by providing a better understanding of risk and returns.
The value factor is an attribute of stocks that are chosen by factor investors. The value factor is based on a belief that stocks that are inexpensive relative to some measure of fundamental value outperform those that are pricier. To this day, different definitions of value are favoured by institutional investors, including cashflows, prices relative to earnings, dividend yield, and other company fundamentals.
Proven factor where stocks with low total asset growth deliver above average returns. The investment factor takes into account each stock’s 1-year company total asset growth.
If a stock has performed well in the past, it usually provides strong returns going forward. A momentum strategy is based on relative returns in a time frame ranging from three months to one year.
Low debt, stable earnings, consistent asset growth, and strong corporate governance define quality. Investors can use common financial metrics such as return to equity, debt to equity and earnings variability to identify and select quality stocks for their portfolio.
Portfolios that are primarily made up of large-cap stocks usually exhibit lower returns than portfolios that have a lot of low cap stocks. Size can be captured by analyzing a particular stock’s market capitalization.
Even though highly volatile stocks can give wild returns when things go well, but empirical research has suggested that stocks with low volatility earn greater risk-adjusted returns.
Profitability is measured by the ratio of gross profits to assets. As far as predicting the cross-section of average returns is concerned, profitability has roughly the same power as the book-to-market ratio (a value measure). Even though they have a significantly higher valuation, profitable firms generate higher returns than unprofitable firms.
Growth measures company growth prospects using historical earnings, sales and predicted earnings
Why Invest in Factors?
Factors have been used to manage portfolios for many years. The fact that active managers and institutional investors use them, is a testament to their effectiveness. With the vast array of data and technology available at investors’ disposal, now is a great time to utilize these great drivers of return in your investment strategy.
What is the Difference Between Factor Investing and Smart Beta
Factor investing, including factor indices, are part of the smart beta trend. But smart beta goes beyond factors.
Smart beta indices include all indices that depart from the traditional method of weighting components by their market capitalization—companies’ individual stock market footprint.
Equally weighted, minimum variance indices, maximum Sharpe ratio, and equal risk contribution indices are all part of smart beta. Many of these index approaches have factor “tilts” but they are a by-product of the index design.
In contrast, factor indices are those that are designed intentionally to capture a specific risk premium, such as value, size, low volatility, quality, or momentum.
What are the risks associated with factor investing?
When factor-based strategies are concerned, investors have a lot of options available to them. Every single strategy is designed in a unique way and might contain different types of risks. Investors should remember to keep the underlying exposures in mind, as it pertains to the outcome they wish to achieve. Risks associated with leverage should be kept in mind by investors who select long-short factor strategies.
What are some of the myths associate with factor based investing?
Myth #1: All documented factors are good factors
Reality: Currently, there are more than 300 documented factor characteristics but not all of them benefit investors and therefore cannot be described as good factors.
Myth #2: Factor investing can be timed
Reality: In factor investing, outperformance and underperformance both occur periodically across different market cycles. Like other forms of active management, the performance of equity factor tilts relative to the broad market is difficult to predict, particularly in the short term. Since the relative performance of equity factor tilts varies over time, it is difficult to profit from these swings through market timing.
Myth #3: Factors will always outperform
Reality: Even factors with the greatest historical performance and the strongest rationale for future expected performance can go through significant periods of underperformance. It is therefore critical for investors to decide in advance if they have the willingness, ability, and time horizon to cope with inevitable periods of relatively poor performance.
Myth #4: Using multiple factors dilutes potential performance
Reality: While using multiple factors seldom leads to absolute top performance, combining factors with a low correlation of excess returns provides a smoother ride through diversification and market turbulence while maintaining the ability to capture potential excess returns over time and improve risk-adjusted returns.
Myth #5: A top-down approach is the only strategy for multifactor investing
Reality: The most appropriate approach for each investor should be based on their individual objectives, constraints, preferences, due-diligence capabilities, and belief sets. In the top-down approach, factor exposure is determined via vehicle selection, with each vehicle targeting a specific factor. This gives the investor flexibility to decide which factors to include in each vehicle and their weighting, the asset manager for each factor, as well as the allocation of each single-factor vehicle. By contrast, according to the bottom-up approach, factor exposures are determined through security selection, with portfolios based on the combined factor exposures of individual stocks.
Just like any other investment method is concerned, returns aren’t guaranteed when it comes to factor investing. While Individual factors have performed well during different parts of the economic cycle and they have stayed less correlated with equity market moves, investors should stay aware of this aspect of factor investing as they investigate whether any particular strategy makes sense with their investment goals. In order to reduce the impact of this cyclicality, you should try a multi-factor investment approach that is diversified across factors.