SMSFundamentals | May 01 2023
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How Factor Investing Can Enrich A Portfolio's Potential
Global markets are dynamic and complex making it challenging to understand what specifically drives investment portfolio returns.
Identifying and leveraging key factors can help investors generate competitive returns, reduce risk, and improve diversification.
Embracing the power of factors can be a game changer for investors seeking to achieve their financial goals.
-Factors are the fundamental building blocks that drive returns across different types of assets in a portfolio
-Macroeconomic and style factors play crucial roles in making portfolios more manageable, less volatile, and better diversified
-Factor-based strategies can be used to select securities that align with specific investment objectives and risk tolerances, but each strategy carries its own set of related risks
By Anuj Sharma
What Are Factors and Factor-Investing?
Factors are like the DNA of investing, providing the fundamental building blocks that drive returns across different types of assets.
"Quality" is a basic example of one factor that exists in the suite of companies; those with vigorous fundamentals.
By investing in a portfolio of quality stocks, an investor can potentially capture excess returns while reducing risk due to their stability and resilience during market downturns.
Factor investing is an approach inclined towards an effective portfolio configuration based on specific factors that influence returns across different asset classes.
By concentrating on these factors, portfolios can become better optimised.
Types of Factors
Investment returns are like a puzzle, where macroeconomic and style factors are the pieces that fit together to form a complete picture.
Macroeconomic factors provide an overview of the risk across asset classes, while style factors illustrate the risks within the asset class.
One of significant macroeconomic factors is economic growth, which links to the business cycle, while real rates determine the risk of interest-rate fluctuations.
Inflation affects investors' exposure to commodity prices, and credit risks come from lending to companies.
Additionally, investing in emerging markets carries specific economic, political, and sovereign risks, with liquidity crucial to avoiding challenges emerging from a liquidity crunch.
Style factors play a crucial role in asset classes. The value factor identifies undervalued stocks based on fundamentals, while the minimum volatility factor looks for lower-beta stocks with stable price movement.
The momentum factor considers stocks with bullish predominance, and the quality factor prioritises financially robust and progressive companies.
Size is essential, as smaller, high-growth companies offer unique opportunities, and the carry factor incentivises holding riskier securities by providing income.
After knowing about the types of factors, let's look at how different factor-based strategies work.
Factor-Based Strategies and Related Risks
Factor-based strategies are used to select securities that align with specific investment objectives and risk tolerances.
Strategies Based on Macroeconomic Factors
One such strategy is the economic growth factor-based strategy, which involves selecting stocks of companies expected to benefit from economic expansion.
Such companies typically operate in industries such as technology, consumer discretionary, or industrial sectors.
This strategy can be sensitive to changes in the business cycle, geopolitical risks, and market volatility.
Another strategy is the real rate factor-based strategy, which selects securities more resilient to changes in real interest rates.
These companies typically operate in industries such as utilities, real estate, or infrastructure, which provide stable cash flows and can provide inflation protection.
This strategy can be sensitive to changes in interest rates and macroeconomic conditions.
Additionally, investors can also use the inflation factor-based strategy, which selects securities more resilient to changes in prices and inflation rates.
Companies in industries such as healthcare, utilities, or energy have historically performed well during inflationary periods.
This strategy can be sensitive to changes in macroeconomic conditions, interest rates, and commodity prices.
The credit factor-based strategy focuses on selecting securities with a lower default risk from lending institutions.
This strategy requires selecting companies with a history of timely payments, strong credit ratings, and a low level of debt.
This strategy can be sensitive to changes in interest rates, economic conditions, and market volatility, which can impact the default risk of these securities.
The emerging markets factor-based strategy involves selecting stocks of companies operating in developing countries with the potential for higher economic growth and returns.
This strategy can be sensitive to political and sovereign risks, such as regulatory changes, corruption, and instability.
The liquidity factor-based strategy focuses on selecting highly liquid and easily tradable securities in the market.
This strategy requires picking large-cap stocks that are frequently traded and have a high trading volume.
This strategy can be less diversified and potentially carry higher transaction costs.
Strategies Based on Style Factors
The value factor-based strategy is a timeless approach that involves seeking out stocks that are undervalued in comparison to their fundamentals.
Investors using this approach look for stocks with a low price-to-earnings or price-to-book ratio.
Investors must be careful not to fall into the illusion of investing in a stock that has become undervalued due to poor company fundamentals.
In contrast, the minimum volatility factor-based strategy focuses on less risky securities than the overall market.
The approach involves selecting stocks with low beta values or low volatility in their historical returns.
Minimum volatility-based factor strategies can be more sensitive to market changes and may not always protect in all market conditions.
The momentum factor-based strategy focuses on securities that have shown upward price trends in the past and are expected to continue the “momentum”.
Investors using this approach look for stocks that have outperformed their peers over a specific period.
This approach has risks, such as overreliance on historical data and potential market inefficiencies.
The quality factor-based strategy focuses on financially healthy companies with a history of solid earnings, high profitability, and low debt-to-equity ratios.
This approach explores stocks with consistent revenue growth, strong cash flow, and a high return on equity.
Investors should be aware: even quality-based factor strategies are not immune to market risks.
The size factor-based strategy requires selecting smaller, high-growth companies with the potential for rapid expansion and higher returns.
This approach carries a higher risk due to the smaller size and potentially less established nature of these companies.
The carry factor-based strategy filters out securities that offer a higher yield or income incentive to hold riskier securities.
This approach focuses on selecting high-yield bonds or dividend-paying stocks to generate steady income.
Carry-based factor strategies can be more sensitive to interest rate changes and other macroeconomic factors, leading to increased volatility and risk.
ETFs (exchange-traded funds) are primary investment vehicles to implement a factor investing strategy globally.
In general, factor ETFs can provide investors with exposure to specific investment factors such as value, growth, quality, inflation, credit, emerging markets, momentum, and low volatility.
Performance of Factor ETFs
The performance of factor ETFs depends on the specific factors being targeted as well as dominant market conditions.
The performance of factor ETFs can be compared with benchmark indices like the S&P/ASX200.
Interestingly, based on the price return over the last 5-years, several factor ETFs have demonstrated their efficiency to outperform or managed to perform closely to the benchmark.
For instance, the iShares Global Consumer Staples ETF (IXI), targeting the factor of economic growth, has delivered a 46.76% price return, outperforming the ASX200's 24.90% price return during the last five years.
Additionally, the Vanguard Australian Shares High Yield ETF (VHY), targeting the factor of carry (income), is delivering a yield of 6.15%, outperforming the ASX200's 4.58% dividend yield.
Myths Attributed to Factor Investing
Factor investing, a popular investment strategy that identifies and leverages specific market factors to generate returns, has become a vital topic in recent years.
Despite its benefits, there are several myths that investors must be aware of before implementing this strategy.
One common myth is that factor investing is a sure-fire way to outperform the market.
While it can potentially generate excess returns, it's not guaranteed, as factors can go through prolonged periods of lagging returns.
While factor investing is often viewed as a passive investment strategy, instead it requires active management.
Another myth is that factor investing is a one-size-fits-all solution.
Different factors perform differently in different market environments. Investors must carefully choose which factors align with their investment objectives and risk tolerance.
Also, Factor investing is also not immune to market downturns.
Many factors can suffer simultaneously, leading to significant draw downs. Investors must continuously monitor and rebalance their portfolio to ensure it remains aligned with their target factors.
Finally, investors must be aware of the risks associated with overcrowding in prevalent factors and the challenges of implementing factor strategies, including index construction, data quality, and trading costs.
In conclusion, factor investing has emerged as a powerful investment approach that can help investors generate returns, reduce risk, and improve diversification.
By identifying key factors that drive returns across different asset classes, investors can build a well-balanced and diversified portfolio that can weather market volatility and economic uncertainty.
A nuanced understanding of macroeconomic and style factors is essential to achieving investment success.
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