What is Factor Investing?
Factor Investing is an approach wherein the investor focuses on identifying the key drivers that push the different asset-class returns (like stocks or bonds). These drivers could be macro-economic drivers or fundamental drivers. Following Factor Investing would allow an investor to dig deeper into the exposures (think risks) for each asset class. Additionally, it would also give a greater degree of control to an investor to enhance diversification and control volatility in returns.
Examples of Macro-Economic Factors: Economic Growth, Interest Rates, Inflation, Credit Supply, Liquidity
Examples of Fundamental Factors: Value, Size, Volatility, Momentum, Quality
Ten Second Definitions:
- Value: Undervalued securities which have strong fundamentals.
- Size: Small-Caps are believed to out perform Large-Cap firms due to their high growth potential.
- Min Volatility: Stable, low risk securities which are resilient during high volatility environments.
- Momentum: Securities that have performed well, will continue performing well and vice versa.
- Quality: Financially strong companies, with healthy balance sheets and financial statements.
The Food Analogy
The concept of Factor Investing can be best visualised in terms of everybody’s favourite topic (or at least mine) FOOD. Andrew Ang (Head of Factor Investing Strategies, Black Rock) beautifully draws the analogy that factors are to a portfolio what nutrients are to a diet. Just like different diets have varied percentages of nutrients ( be it, proteins, carbs, fat, vitamins or minerals), different portfolios have varied exposures to a plethora of factors. Based upon the client’s Investment Objective, a portfolio manager can devise an allocation with factor exposures which are appropriate, in order to meet the clients goals. Think of this as tailoring your diet, focusing on those “MACROS” like high protein, low carbs, in order to get that summer body you’ve been dreaming of!
Examples of Factor Based Strategies
(a) Smart Beta: It is a subset of factor investing, focusing on fundamental factors under a particular asset class (like stocks or bonds). These strategies are typically, long-only index based strategies utilising ETF’s for their allocations.
WOW lots of words there right? Let me break it down for you. Being “LONG-ONLY” implies that you want to BUY the particular stock (yes, it’s also possible to SELL a stock without owning it, that means you’re SHORT the stock). “INDEX-BASED STRATEGIES”, implies investing in Indexes like say the NIFTY50 using a financial instrument called the ETF (Exchange Traded Funds). “ETFs” in the most simplest terms are just like Mutual Funds but they are traded on stock exchanges like the NSE or BSE just like stocks are! Cool right?
(b) Single Factor ETFs: Factor portfolios constructed to have exposure to a single factor like Size, Value, Quality, Momentum, etc. Um think, pizza’s (ETF’s) with a single topping (the factors).
(c) Multi Factor ETF Strategies: Portfolios with exposure to multiple factors usually defined by their theme like Global Macro based strategy, Emerging Markets strategy, USA based Multi-factor strategy, etc. You got the hang of this already, Multi Factor ETF Strategies are just like pizza’s with a variety of toppings!
And that’s a wrap for this week! 🙂 Stay tuned for new articles every week, demystifying Finance for Gen A to Z.
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One reply on “Introduction to Factor Investing”
[…] So essentially we have two cohorts of factors, namely, macro-economic factors and style-based factors. To get a more detailed introduction to Factor Based Investing, check out Part I. […]