What is factor investing? Can it outperform in volatile markets?

Key Takeaway

• Factor investing entails investors picking assets based on specific qualities linked historically to higher returns or lower risk, rather than company performance or broad market indices.
• Advantages include a rule-based investment strategy, asset diversification, and the ability to customize investments to different risk appetites and investment goals.
• Factor investing is well-suited for volatile markets, facilitating risk-adjusted returns through a systematic and transparent approach to investment options.

In a volatile market, investors try several approaches to ensure that their portfolios deliver improved risk-adjusted returns. Factor investing is one such strategy. Instead of following the market, investors use certain characteristics of stocks and macroeconomic factors to make their investment decisions.

Factor investing originated from the Capital Asset Pricing Model (CAPM), which explains how a particular asset can provide a return compared to the risk associated with the overall market. While CAPM offers a basic idea of pricing assets, stock returns do not precisely follow the model’s framework. Instead, data shows that stock returns are often linked to their characteristics.

This blog explains how factor investing works, its benefits, risks, and real-world performance.

What is factor investing, and how does it work?

Factor investing is an investment strategy in which investors pick assets based on specific characteristics, referred to as ‘factors’, that they believe are historically linked to higher returns or lower risk. For this, the investors focus on qualities that indicate a stock’s success rather than relying on traits like the performance of a particular company or broad market indices, CFI explains.

What are the factors behind factor-based investing?

According to State Street, different firms recognize different ‘factor’ lists. Still, five common factors – known as style factors – have historically outperformed the market or reduced a portfolio’s level of risk over the long term. Let’s take a closer look at these five style factors:

1. Value: Value stocks are those that trade at a low price relative to their fundamentals, such as earnings or sales. They tend to outperform the broader market over the long term, possibly a reward for taking a smart risk at the right time.
2. Quality: This factor focuses on high-quality companies with low debt, stable earnings, and high profitability. Due to their strong fundamentals, these companies tend to deliver more substantial long-term returns.
3. Size: Small-cap stocks have often provided higher returns than large-cap stocks over time. Initially, these stocks are less well-known and get less analyst attention; hence, most investors view them as risky and choose to avoid them. However, investors keen on investing in small-cap stocks must hold several of them to reduce the portfolio risk.
4. Low volatility: Low volatility strategies offer consistent returns and are well suited for generating strong long-term performance. However, many investors miss out on this opportunity as they often ignore ‘boring’ low-risk stocks and chase the ‘exciting’ ones.
5. Momentum: Stocks performing well at the current time tend to outperform the market in the short term. Investors who add these momentum stocks to their portfolio may achieve impressive gains in the short term.

It is important to note that style factors explain risks and returns within each asset class. In addition, macroeconomic factors like economic growth, inflation, and interest rates, among others, explain risks across multiple asset classes.

Yield is also a smart factor to consider. High-dividend stocks often perform better than stocks with lower yields.

Advantages of factor-based investing over traditional methods

• In factor investing, investors use data and follow a rule-based investment strategy, which reduces human biases.
• Diversification of assets reduces portfolio risk. If an investor adds an additional element of investment style, like factor investing, to their existing portfolio, it enhances diversification benefits.
• Since investors prioritize factors aligned with their specific interests, the strategy caters to investors with different risk appetites and investment goals.

What are the risks associated with factor investing?

When investors decide to follow factor-based investing, they are presented with too many options, increasing the risk of making the wrong choices. Each factor investing strategy is uniquely designed and carries its own risks; therefore, investors must understand the underlying exposures concerning the outcomes they aim to achieve.

How does factor-based investment work in volatile markets?

Factor-based investing is well-suited for a volatile market when the goal is to deliver risk-adjusted returns by improving the investor’s selection through a systematic and transparent approach.

A J.P. Morgan study looked into how factor investing worked during the COVID-19 crisis, to assess how a factor-based investment strategy works in a volatile market. The analysis looked at four periods between January and June 2020, and here’s what it revealed:

• Period 1 (time before the market crash): Markets looked positive just before the coronavirus outbreak, and factor strategies provided decent returns.
• Period 2 (market crash): As predicted, factor investing added value to the portfolios when markets dropped sharply due to economic shutdowns.
• Period 3 (stimulus-driven rally): These strategies struggled as markets were driven by government intervention and unprecedented central bank stimulus. Again, this was expected as factor investing struggles in liquidity-driven or technical-driven rallies.
• Period 4 (stabilization): During this time, factor strategies delivered flat returns as markets steadied and resumed their upward trend.

The report also examined how individual factors performed during the stress period. It showed that the ‘quality factor ’outperformed when the market dropped but lagged when it bounced back. The ‘value factor’ struggled during the market sell-off but added value to the portfolios once the market started to recover. The momentum stayed steady during the downturn but fell during the rebound.

Who should consider factor investing?

Before jumping into factor investing, investors should consider that individual factors perform differently in different economic cycles, and performance is not guaranteed. Hence, they should carefully assess whether a particular strategy aligns with their investment objectives, a BlackRock report stated.

A good factor investing strategy is to opt for multi-factor investing. Diversification across factors reduces portfolio risk significantly.