Factor Investing – How does it work?

Factor Investing – How does it work?

30 July, 2020

The selection of players in a cricket team based solely on talented batsmen and bowlers is an outdated criterion. The Indian cricket team too learned it the hard way in the 2000s. This was followed by the veteran rotation on Dhoni’s arrival as captain. The Indian cricket team today has a number of stats looked into to form a selection strategy.

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These include fitness levels, susceptibility to injury, player image, etc. The 2008 crisis due to bond market failure similarly made investors realize that simple diversification of a portfolio based on asset classes wasn’t enough. This gave rise to an investment strategy called Factor Investing.

What is Factor Investing?

Factor investing is a completely different way of looking at diversification. It is built on Eugene Fama and Kenneth French’s work. Fana termed it highly difficult for even professional investors to exceed market performance. According to him, it would be better to invest in a broadly composed portfolio of stock instead of engaging in futile stock-picking efforts.

Researchers noticed that throughout history stocks with particular factors in play were able to perform better. As research emerged certain factors stood out and were applied to a portfolio in order to create an Alpha.

What is an Alpha?

In simple words, the over and above performance of a fund over a benchmark for a long period of time it is said to be an Alpha (α). Say the Sensex rises at 15% in a year and your respective portfolio at 18%. Then the additional 3% is known as Alpha. However, Alpha’s are known as imaginary creatures of the market world. This is because no funds have been able to beat the markets consistently for a long period of time ( Not just 1-3 years).

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Factors involved in factor investing

The following factors are widely used and regarded to have added to the Alpha.

1. Beta ( β)

Yes. We do require the Beta in our search for the Alpha. Beta here represents the risk. The Beta of a stock is arrived at after observing how volatile and sensitive the stocks are. Regression analysis is used to arrive at Beta.

Here is a non-quantitative method we may use to arrive at the estimate of the Beta. Firstly, plot the market movement on a graph for a  particular period. Then plot the market movement of the security in question

Case 1: If the security pretty much tracks the market then β = 1.

Case 2: If the security is more volatile than the market then β >1.

Case 3: If the security has lesser volatility than the market then β < 1. 

Factor Investing does take on considerable risk. It considers that the greater risk the portfolio involves itself in the greater is the return. If we assume that the Beta of the portfolio is 1.5. Then if the market moves upwards by 10% it would lead to the portfolio rising up by 15%. However, if instead, the market moves downwards by 20%, the portfolio will fall by 30%

2. Size

Unlike the conventional approach, this approach requires investing in small-cap stocks. If we are to look at it with an open mind it would make sense as small-cap stocks would have a greater possibility of making leaps in growth when compared to their small value. Larger cap stocks although rock-solid to weather a market storm would have slower growth rates. As per CRSP data from 1927 to 2015 small-cap stocks would provide 3.3% higher returns than large-cap companies.

3. Value

According to this factor, a less expensive stock would prove more beneficial than a stock that is more expensive. It encourages investing in undervalued stocks. This approach works theoretically as investing in companies whose prices may fall but their strong fundamentals remain the same would prove more beneficial.

This is in comparison to investing in companies that have rising prices but with the same fundamentals. The inflated security would be adjusted during a market correction but one with strong fundamentals would still prove beneficial. As per CRSP if stocks with incorrect prices are bought then the difference in returns as per data from 1927 to 2015 would be 4.8% per year.

4. Momentum

This factor requires including stocks that have had an upward momentum in the portfolio. It requires a ranking of stocks based on 12 months trajectory and excluding the latest month. As per data compiled by CRSP from 1927 to 2015, the top 30% of stocks with upward momentum would provide 9.6% additional returns in comparison to the stocks from the bottom 30% that may have had a downward trajectory.

5. Quality and Profitability

According to this factor, a high-quality stock with high profitability would generate excess returns. As per ‘ A Complete Guide to Factor-Based Investing’ high-quality companies have the following traits: low earning volatility, high margins, high asset turnover, low financial leverage, low operating leverage, and low stock-specific risk.

As per data compiled by CRSP from 1927 to 2015,  the stocks forming the top 30% of Gross Profitability gave 3.1% higher returns than those of the bottom 30%.

How were these factors identified?

For a factor to be considered, it is necessary that it satisfies the following tests.

— Persistence

According to this, it is necessary that the factors will show up through time and are not limited to  a specific time period

— Pervasive

The factor must hold true across various regions countries and sectors

— Robust

The factor must not change if you change how the characteristics are defined and must be robust to specification.

— Investible and Sensible

The factor must be sensible and add value. Further, they must be investible if it is to be bought into the portfolio.

Results of Factor Investing

Historically one of the most prevalent investment strategies has been Active Investment. In Active Investment, a fund manager along with his team of analysts strategizes and analyses individual stocks to beat the market. In Active Investment the skill of the investment manager enables a fund to perform better than the market. The operations of the fund involves hedging and a lot of buying and selling activity takes place.

Another form of investing is Passive Investing. Here the portfolio tracks the market. In Passive Investing the investors are in for the long haul. The buying and selling that takes place are lower than those compared to Active investing. The expenses are significantly lower in comparison as Passive Investment uses programmed computers in place of fund managers.

Factor Investing can come into play by combining the Active Investment strategy and the Passive Investment Strategy. The Active Investment strategy can be used to acquire a portfolio apt with the factors and this can be programmed into a computer. The software will be able to replicate the strategy and at the same time analyze swaths of stocks. Factor Investing, if done right, results in a highly diversified portfolio. This further alleviates the risk faced through stock picking and enhances the portfolio with factors.

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Why isn’t Factor Investing popular?

Even though factor investing is thrown around a lot in financial jargon it still has been limited in usage. It can be because of the following factors.

1. Keen on Risk

Factor investing is based on the principle the more risk you are willing to take the more probable gains await you. Risk-averse investors generally tend to avoid factor investing. Apart from risk avoidance, certain investors may not even believe in the possibility of the fund beating the market. This is because in the year 2017 only 15.77% of the funds in the US beat the market and even fewer in the long run.

2. Research

Factor investing has been well studied in the equities market. But there is still not enough research done for other assets like options futures etc.

3. Expensive

Although factor investing is cheaper than active investing and is still more expensive in comparison to Passive Investing. The problems are further alleviated as factor investing takes a longer time to reduce the odds of underperformance. Even if the fund performance beats the market the excess should also beat the additional expenses charged due to factor investing.

Closing Thoughts

Eugene Fama was recognized with the Nobel Prize in 2013. This did bring additional interest to the field of factor investing. Since then there are been multiple pieces of research and over 300 factors have been claimed to be discovered. Despite all these efforts, the perfect factor investing model is still unknown.

The Indian markets currently have the following Indexes available in the Indian markets. They are NIFTY Alpha Low-Volatility 30, NIFTY Quality Low-Volatility 30, NIFTY Alpha Quality Low-Volatility 30, NIFTY Alpha Quality Value Low-Volatility 30. According to Akash Jain (Associate Director, S & P BSE Indices), the BSE has tested four factors in the Indian context: Quality, volatility, momentum, and value in down markets. They noticed that low volatility gave significant excess returns and in the up markets value tends to outperform. Low volatility here acts as a defensive factor and value enables stocks to perform well in macroeconomic conditions.