1. What is factor investing?
The simplest definition of factor investing comes from Investopedia, where it is defined as an investment approach in which securities are ‘chosen based on attributes that are associated with higher returns’. Factor investing, it continues, requires investors to analyze stocks using a ‘greater level of granularity; specifically, more granular than asset class’. It lists some common factors used: ‘style, size and risk’, which begs the question: what is meant by style, size and risk?
Style investing is tilting your portfolio to small cap versus large cap or value versus growth; size factors in high or low market capitalizations; risk – fortunately and unfortunately – is self-explanatory and can include both high and low-risk portfolios.
But there is now a larger range of criteria, which Ian Webster, writing for Axioma, gives as:
- Value = undervalued relative to corporate fundamentals
- Growth = above-average earnings growth
- Momentum = rate of acceleration of price
- Volatility = dispersion of returns
- Size = high or low market capitalization
- Liquidity = low trading volume
- Yield = income return on investment
- Quality = sustainable profitability
Not all of these factors are used by every factor-investing index; different funds choose single or multi-factors to construct indexes. The MSCI family of factor indexes, for example, according to a Research Insight report by Jennifer Bender from 2013, uses only value, low size, momentum, low volatility, dividend yield and quality.
2. How popular is it?
Some date factor investing back to the research published in 2009 by Andrew Ang, a former professor of business at Columbia Business School and now head of factor investing at BlackRock, but Allianz Global Investors takes it much further back ‒ not just to the capital asset pricing model devised by William Sharpe in 1964, but further back to Benjamin Graham and David Dodd’s Security Analysis, written in 1934, which first mentioned the ‘value premium’.
Its spectacular growth, however, is much more recent. At the end of 2015, for example, Morningstar estimated the factor-investing industry to be worth €369 bn ($417 bn), four times its value in 2010; if private mandates are included, the industry could be worth almost two and a half times that. An anonymous source at the IR Magazine Think Tank ‒ Euro Leaders 2016 commented: ‘Factor-based investing is something that has risen something like fourfold over the last decade if we look at the Morningstar figures, and it is expected to rise at a double-digit pace over the next few years while active equity management is expected to grow only minimally.’
Most funds now have several factor-based exchange-traded funds (ETFs) that investors can choose.
3. Why should IROs know about it?
That same anonymous source said: ‘From an IR professionals’ perspective, thinking about the daily price performance of your own stock is an increasing function of the kinds of factor models you’re screening. It might be that, without even knowing it, you’ve become part of a smart-beta ETF that gives you exposure to a certain characteristic.
‘So I think this is really about awareness for IR professionals and active managers, and for investors it’s really about hedging out any factors they don’t want to be exposed to. We are seeing an exceptional increase in rules-based and factor-based investing ‒ we are seeing increasing awareness of it across the investment community.’
The takeaway from this is to make sure you know what factor-based ETFs you’re a member of. Most funds and indexers have factor-based funds – BlackRock, Vanguard, Goldman Sachs, JPMorgan – so this might not be the easiest data to collect, but it is important to know.
