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Factor-based Investing: Targeting the Real Drivers of Return

Factor-based investing generally refers to a category of rules-based approaches to investing. Understanding each of the factors can help to choose the right mix of exposures according to an investor’s risk tolerance and investment goals.

Factor-based investing – or smart beta – generally refers to a category of rules-based approaches to investing. These strategies seek to capture specific factors, or investment characteristics, such as the size of a company, Volatility, Valuation or Quality profiles. Factor-based investing can help investors achieve returns in excess of more straight forward market capitalisation weighted indices: research has shown that between 50% and 80% of a portfolio’s excess return can be attributed to exposure to specific factors, such as low volatility or size.1

Once factors are understood, factor-based investing is a straightforward, systematic and cost-effective approach to generating returns.

Although factor-based investing strategies may be attracting much attention in recent years, the underlying investment philosophy has been around for several decades. It was first introduced through the capital asset pricing model (CAPM) in the 1960s, which suggested that a single factor – market exposure - helped to explain a stock’s performance relative to its index. Essentially, this argued for market capitalisation weighting as a good starting point for investment decisions.

The Factors Behind Factor-based Investing

Factor-based investing, or smart beta funds, track indexes that are constructed around one or more factors. There are five common factors that have historically outperformed the market or reduced a portfolio's level of risk over the long term. While some investors may tout complex definitions, most are not robust enough to explain return once the following five factors are accounted for. The factors to seek exposure to are:

Value: Value stocks are those that trade at a low price relative to their fundamentals, such as earnings or sales. They have been shown to outperform the broader market indices over the long term, potentially due to investors’ behavioural biases and the reward for taking additional risk/providing liquidity in a stressed environment.

Quality: This factor focuses on companies with low debt, stable earnings and high profitability. Higher quality companies seem to be rewarded with higher returns over the longer term because they have been shown to be better at deploying capital and generating wealth than the broader market.2 This is particularly true in times of market stress when a company’s ability to service debt and provide visibility on earnings becomes more important.

Size: Small-capitalisation stocks have tended to outperform their large-capitalisation peers over time.3 There are a number of potential drivers for the long term strong performance of smaller capitalisation securities. Their smaller size means they are generally considered to be riskier (less diversified, less covered by analysts and less well known), which has two implications. Firstly, investing in small capitalisation companies requires a well diversified portfolio to mitigate stock specific risk; secondly, the market demands a higher expected rate of return for holding them – the so-called “small capitalisation premium”.

Low Volatility: The long term historic out performance of low volatility strategies may be explained by the theory that some investors overlook “boring” low volatility stocks in favour of “glamorous” ones and, in the process, miss out on the consistent returns low volatility stocks can offer. The implication of this is that the risk/return relationship holds between asset classes, but not necessarily within an asset class.

Momentum: Empirical evidence shows stocks that have done well recently may have greater potential of doing well in the near term than the broader market, and stocks that have performed poorly continue to perform poorly.4 Portfolios which consider momentum can benefit from the momentum in stocks over the shorter term.

Other Smart Beta Factors to Consider

Different firms recognise slightly different factor lists, but the factors above appear in most published lists.

In addition, Yield may be a smart beta factor to consider. Over the long term, stocks with higher dividends tend to perform better than stocks with lower yields, possibly due to the Value or Quality characteristics of yield.5

Combining Multiple Factors

Understanding each of the factors can help to choose the right mix of investments according to an investor’s risk tolerance and investment goals. It is also important to note each factor performs differently in different market conditions. Quality and low volatility strategies tend to outperform in market downturns, while value strategies usually deliver strongest returns in risk-seeking environments.

Because different factors may perform well at different times, investors may want to consider investments that diversify across multiple factor strategies. A multi-factor investment aims to target improved performance characteristics. Combining, for example, volatility, value and quality factors may offset the cyclicality of single-factor performance, and achieve smoother returns over different business cycles.6