No matter your experience in the stock market, the overall goal is the same: to make as much money as possible. Who doesn’t want excess returns?
Everyone seems to have their own method for creating market-leading gains. When reading this article, you may notice certain themes appear, like tracking volatility and momentum, paying attention to the size of companies, and looking for undervalued plays.
Surprising as it seems, the vast majority of long-term investment strategies that have the potential to beat market benchmarks fall into the category of factor investing strategies.
What Is Factor Investing?
Factor investing is a broad strategy for generating higher returns while increasing diversification and managing risk. Investors who practice factor investing aim to increase profitability by focusing their asset allocation on risk factors when making decisions in equity markets.
One of the most famous investors in the world, Warren Buffett, is known for a focus on one of the most popular factors on the market: value. The billionaire investor is constantly looking for opportunities to pounce on undervalued stocks in an attempt to make a mint as the market balances and the price of the stock moves to a fair market valuation.
Overall, factor investing involves investing in stocks that pay a premium for a minimally-increased level of risk. Value is just one of many such factors.
After all, value stocks that are undervalued often bounce back, but there’s also a chance a stock is valued lower due to a systemic problem or corporate mishaps that will continue to weigh it down. By taking on that risk across many investments over time, Buffett and other value investors’ portfolios beat the market time and time again in the long run.
There are two different types of factors to pay attention to, including style and macroeconomic factors. Here’s what to look for.
Common Types of Style Factors
When investing in risk-premium factors, you have the option of focusing on a single factor or a mix of factors as criteria for your investment activities.
Each risk-premium factor comes with both the potential to generate higher returns than average and a slightly elevated level of risk. Nonetheless, these factors have become popular because, historically, the benefits have outweighed the risks.
The risk-premium factors that are known to be the largest drivers of returns include:
Like Warren Buffett, value investors focus on a wide range of valuation metrics in an attempt to find stocks trading at a discount in hopes of reaping the rewards on the upside.
The value factor requires close attention to fundamental financial data on a company, including free cash flow, dividends, and metrics like the price-to-earnings ratio (P/E ratio) and price-to-sales ratio (P/S ratio).
The biggest risk associated with investing in value stocks is the potential for there to be a reason for the undervaluation that the market is pricing in. For example, a recent rejection from the FDA could send a biotech stock on a dive, resulting in low valuation metrics, and the risk associated with investing in the company would likely outweigh the benefits of the undervaluation.
The momentum factor is an exciting one, as it focuses on stocks that are already moving in the right direction with significant momentum. Newton’s first law of motion suggests that a body in motion stays in motion, and that’s often true in the stock market.
A stock that’s enjoying high momentum and liquidity while beating average market returns could continue to do so for some time. Momentum investors look for technical clues of big upswings so they can get in at the beginning of a wave of buying.
On the other hand, chasing momentum can be a relatively dangerous game. Momentum stocks are often overvalued, and a sudden correction may be lurking around the corner. If you’re focusing on the momentum factors, pay close attention to technical data, and be ready to get out when the time comes.
The volatility factor points to stocks that experience low levels of volatility. That’s because, historically, stocks with lower levels of volatility have generally earned greater risk-adjusted returns than high-volatility stocks.
On the other hand, low-volatility stocks don’t tend to produce jaw-dropping short-term gains. So, this is a factor better suited to long-term investors than short-term investors.
The quality factor is measured using a wide range of metrics, with the most common being a company’s debt-to-equity ratio, return-to-equity ratio, and earnings variability.
Regardless of which metrics you use as a measurement, the idea is to invest in high-quality companies with stable earnings, consistent growth, strong management, and low levels of debt.
Quality factors including those mentioned above should always be considered when making investment decisions. After all, companies with stable earnings, consistent growth, strong management, and low levels of debt are likely to outperform lower quality stocks.
When using factor investing, you should consider the quality of the stock before accepting the risk. For example, if you’re into value investing, you should look for stocks trading at lower-than-average valuations that display strong quality signals.
Finally, the size of a company is another widely accepted risk-premium factor.
Investors who pay attention to the size of the companies they invest in as a way to increase returns tend to focus on small-cap stocks, which have historically outperformed their large-cap counterparts.
However, there’s an art to investing in stocks with a small market cap. These companies aren’t as well established as large-cap players, and therefore often come with some added risk.
Example: The Fama-French 3-Factor Model
The Fama-French three-factor model is one of the most commonly used factor-investing models. It acts as an expansion to the widely used capital asset pricing model (CAPM), which measures the relationship between risk and expected returns for an asset. The Fama-French three-factor model was developed by Eugene Fama and Kenneth French.
The Fama-French three-factor model is centered around three style factors:
- Size. The model gives preference to small-cap stocks over large-cap equities.
- Value. The model relies on the book-to-market-value metric to determine if the stock is undervalued.
- Momentum. The model looks into the excess return the stock has generated compared to the broader market.
The style of investing suggests investing in smaller companies with strong value metrics and that have a relatively strong historic performance compared to the broader market will generate outsize returns.
Factor Investing with Mutual Funds & Exchange-Traded Funds (ETFs)
If you’re not interested in picking your own list of stocks, investment-grade funds like exchange-traded funds (ETFs) and mutual funds offer a low-cost way to take advantage of the factor investing strategy.
Several ETFs are built around risk-premium factors. For example, the Vanguard Small-Cap Value ETF (VBR) focuses its investments on two style factors — size and value — and has a strong history of outperforming the overall market.
If you don’t have the time or ability to build your own investment portfolio, consider looking into investment-grade funds with investment management styles that focus on risk-premium factors.
Pros of Factor Investing
There are several reasons to consider diving into factor investing strategies. Some of the most exciting benefits to these strategies include:
Who doesn’t want to make more money in the market? After all, money making is the name of the game. Factor investing was designed to make that possible. By leaning on factors that are likely to produce larger returns, this style of investing gives investors a simple yet effective way to beat the market.
No Emotion Allowed
When using factor investing, investments are made based on the risk-premium factors you choose to focus on. Following this type of strategy leaves no room for emotions like fear and greed to take hold and devastate your returns.
Cons of Factor Investing
While there are plenty of reasons to consider following a factor-investing strategy, there’s also a significant downside that should be taken into consideration before you start.
Factor investing is all about choosing to minimally increase risk in exchange for the potential to produce significantly higher profits. While the potential for profit generally outweighs the increased risk involved, it’s important to be clear in your research and understand all the risks that may be involved before diving into any investment.
Is Factor Investing Right for You?
The truth is that when managed properly, an investing portfolio that includes a focus on risk premium factors is a strong choice for just about anyone. After all, who doesn’t want to beat average market returns over the long run?
However, there is one class of investor for whom this investment style isn’t a good fit. If you’re nearing or in retirement and extremely intolerant of risk, the increased risk you must accept to take part in these strategies will likely be a turn-off.
If you’ve already got a nest egg that you’re actively drawing upon, you may not be able to afford to take additional risks in the here-and-now in exchange for a higher potential payoff in the long run.
Factor investing offers an exciting opportunity to follow in the footsteps of countless investors who consistently outperform widely accepted benchmarks. However, it’s important to remember that increased potential earnings simply don’t exist without increased risk.
While research is important regardless of your investment style, the need for research grows more acute when accepting additional risk. If you’re interested in adding a risk premium or two to your portfolio, be sure you’re willing to do the research required to be successful in doing so.