Factor Investing

There are many ways to skin a cat, or so the saying goes, and is especially true with investing. Factor investing is just one method among a plethora of methods in constructing a portfolio of assets. It can be applied to both equity (shares) and fixed income (bonds) but is more usually associated with the former. This article will focus on factor investing in terms of equity.

Factor investing involves identifying shares with a specific characteristic, with the intention of building a portfolio that targets this characteristic. A common technique is to build a portfolio that is diversified across various factors.

What is a Factor

To go any further we would need to define a factor. The classic factors usually targeted are value, growth, size, quality and volatility. Identifying which factor(s) a share exhibits is generally a mechanical process and defined by predetermined metrics.

It’s essentially an include or exclude decision, if the share does not achieve a metric requirement for a certain factor, the share is excluded from that factor category.

The Value Factor

Value investors are looking to buy shares that are, for whatever reason, trading below their intrinsic value- read: the true share price of the company. They’re essentially looking for a bargain.

Value shares naturally offer a form of capital protection since their price is already low. So if a major systematic (market) event occurred that caused the market to “crash”, chances are these shares wouldn’t suffer the same impairment as their overvalued counterparts.

A value investor is hoping the market realizes how cheap the share is relative to the quality of the company, thus increasing the demand of the share and increasing the share price.

This can take a while though, so value investors are long-term oriented. Even if the share price doesn’t increase for a while, if the dividends remain the same or even increase, the value investor still makes a return from the dividend income.

The value investor also needs to be aware of the “value trap”. This occurs when a stock appears to be undervalued according to its metrics, while in actual fact the low price is justified. When a value investor is unable to identify if the low price is legitimate, it may result in losses as the stock price depreciates further.

The classic metrics for the value factor are a low price-to-earnings (P/E) ratio, a low price-to-book (P/B) ratio and a high dividend yield (D/P).

The Growth Factor

Growth investors are looking to by shares of companies that have great prospects for, you guessed it, future growth. Their looking to ride the popularity wave of the share, which can be a significant force. These shares are generally overpriced according to their intrinsic value, so growth investors inherently pay a growth “premium”.

Growth investing does not carry the same degree of capital protection as their value counterparts. The saying applies: the bigger they are the harder they fall. However, the prudent growth investor should investigate the size of the growth premium relative to their assessment of the stocks future growth potential. This can help guide them in avoiding a very overvalued stock.

The classic metrics for the growth factor are exactly opposite to value factor, namely a high price-to-earnings (P/E) ratio, a high price-to-book (P/B) ratio and a low dividend yield (D/P)

The Size Factor

An investor who has a size focus generally has a bias towards either a large company or a small company. Generally, smaller companies tend to outperform larger ones since they are relatively more flexible in their operations. Able to quickly adapt to a changing market.

Large companies on the other hand, are generally well established in the market and can withstand significant market shocks while the smaller companies may struggle, despite being more flexible.

The classic metric for size is simply the size of the company’s market value, that is the amount of shares outstanding multiplied by the current market price. It’s an easy factor to target since it’s a straight forward process to calculate a company’s size. In the South African market, this is already split between the JSE Top 40 and the JSE Mid-cap.

The Quality Factor

The quality factor has a focus on the company’s operational efficiency. With more efficient company’s outperforming their less efficient counterparts. Further to this, a company’s efficiency is often a sign of the quality of management. While the factors discussed previously are based on metrics that don’t really reflect management’s performance.

The classic metrics for quality include a high return on equity (earnings per share divided by book value per share), low accruals ratio (which indicates the extent to which the company made revenue in actual cash) and low financial leverage (which indicates the how much debt the company have relative to equity).

The Volatility Factor

While the previous factors seek to achieve returns associated with specific factors, thus improving the return characteristics of the portfolio. The volatility factor seeks to improve the risk characteristics of the portfolio. The investor focused on the volatility factor will seek out stocks that display lower, rather than higher, volatility.

The classic metrics used in identifying the degree of volatility a stock displays is the standard deviation of the stock’s return, as well as their beta (which is the stock’s return relationship to the general market).

Which Factor(s) to Target

As with all instances of the investment decision, the choice of which factor(s) to target is unique for each individual. To get you thinking, the table below may provide some guidance.

Factor investing defensive aggressive conducive market condition

The Implicit Risk with Factor Investing

Factor investing is a rules based approach – i.e. including stocks that fit specific metrics. It results in helping remove the emotional biases that may occur with investing and allows individuals to be objective in their decision making.

One very important consideration to keep in mind is that a rules based approach may result in a concentration of stocks that share similar risks. So although there may be good intentions behind targeting a certain factor, the portfolio may become too concentrated in the specific risk shared by all the stocks exhibiting a single factor.

The best method to mitigate this risk is by employing an equal risk-contribution weighting approach. The way this works is by analyzing the volatility (standard deviation of returns) of each stock, as well as each stock’s correlation with each other.

This results in a portfolio that has higher weightings in stocks that exhibit lower contribution to the portfolio’s total risk, while having lower allocation to those stocks that contribute a higher amount of risk to the portfolio. The effect is a well diversified portfolio that still targets a specific factor.

How to Access Factor Based Investment Vehicles

In theory the factor investing rules based approach is straight forward to implement. In reality though it’s a significant undertaking and time consuming. Further, the necessary analyses that needs to be done to mitigate the factor risk is even more daunting.

Fortunately the rules based approach of factor investing makes it an ideal candidate for an exchange traded fund (ETF). In fact, the majority of ETFs are constructed with factor investing in mind and you’re able to access each factor discussed in this article with ease.

Different ETFs offered by different asset managers will have their own rules dictating the requirements for each factor. The beauty of an ETF is that the rules these asset managers follow are available for everybody to see. So instead of sifting through all the available stocks to invest in yourself, you can simply read the ETFs method and determine whether it’s suitable for you or not.

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