In many areas of life, we naturally follow rules and set boundaries, yet when it comes to investing, we often jump in without a structured plan. This can create a mismatch between expectations and outcomes, especially when high return hopes meet limited research or understanding. To avoid such pitfalls and move beyond the misconception that markets are driven only by chance, a more disciplined framework can help. One such framework is factor investing, which brings clarity and structure to the investment process by identifying the underlying drivers of equity returns.
What is Factor Investing?
Factor investing involves attributing the returns of your equity portfolio to specific factors such as value, quality, volatility, and market capitalisation. These factors act as persistent and well-documented drivers of asset class returns, offering investors insights into expected returns and aiding in seeking outperformance or managing risks effectively. With the accessibility of Exchange Traded Funds (ETFs), factor investing is no longer confined to the elite, presenting a balanced mix of passive and active investment management.
Understanding Long-term Drivers of Equity Returns
Value Factor
This factor indicates that stocks with low P/E multiples or high earnings yield tend to offer higher returns, especially during stock market recoveries.
Momentum Factor
Strong price momentum effects have been observed in various asset classes globally, indicating that past winners continue to outperform losers.
Growth Factor
This factor gauges a company’s potential based on historical or projected growth rates, signalling potential strong future stock price performance.
Quality Factor
The quality factor is based on complex accounting information, focusing on companies with little divergence between accrual and cash earnings.
Size Factor
Smaller companies, such as midcaps and smallcaps, are believed to outperform larger peers over the long run due to untapped markets and growth potential.
Application of Factor Investing in Building a Robust Investment Portfolio
Timing factor exposures precisely is challenging, akin to timing the market. A multi-factor approach, rather than exposure to individual factors at different times, helps reduce factor-specific risks without compromising portfolio returns. Investors can adopt this approach while remaining bullish on a specific factor, adjusting exposure accordingly.
Pros of Factor Investing
- Sits between passive and active approaches, appealing to investors on both sides.
- Enhances returns for passive investors with defined costs and risk attributes.
- Backtesting factors over extended periods provides historical insights.
Cons of Factor Investing
- Factors have specific cycles of outperformance and underperformance, making predictions challenging.
- No single factor works across all market conditions, requiring proactive adjustments.
Conclusion
To conclude, factor investing provides a systematic way to understand and navigate the variables that influence a security’s performance. While no single factor works across all market conditions, a well-designed multi-factor approach can help balance risks and reduce reliance on any one theme. For investors seeking a clearer, more structured method of portfolio construction, this approach offers a middle ground between passive simplicity and active strategy allowing decisions to be grounded in evidence rather than emotion.
*The article is for information purposes only. This is not an investment advice.
*Disclaimer: Teji Mandi Disclaimer
Note: This article was originally written by Teji Mandi for ET Markets.
