Factor Investing: What it is, Types, Pros, Cons, and More

By Chainika Thakar

Factors to investment decisions is what nutrients are to food. On the basis of nutrients, you decide which food to consume, and how much. Factors are integral for learning about risks and returns for a particular investment approach.

Hence, every individual trader will look to invest in stocks with similar factors for risks and returns in accordance with the trader’s affordability of risk for every generated return. Further in this article, we will find out about factor investing in detail.

This article covers:

• What is factor investing?
• Types of factor investing
• How does factor investing differ from smart beta?
• Pros of factor investing
• Cons of factor investing

What is factor investing?

Factor investing implies the investment approach that makes use of “factors”, or the particular “characteristics” that make the various stock returns differ from each other. Such factors include volatility, momentum, size of the stock etc.

While creating a factor based investment strategy, tweaking of the portfolio (including or removing factors) takes place in such a way that the factors of the portfolio assets generate favourable long term investment returns.

Factor investing has evolved over a period of time from being only market and company-specific to various factors. Here is the image to portray the same:

Types of factor investing

The two types of factors or characteristics of a portfolio are:

Macroeconomic factors or characteristics

These are the ones that capture broad risks across asset classes for the returns. Further, some simple examples of macroeconomic factors are:

Economic growth

Economic growth is an extremely good factor for stock returns and economic growth forecasts lead to an optimum allocation of investment decisions. With a positive economic growth, Gross Domestic Product (GDP) rises and hence, more investments take place in the financial markets.

For instance, when COVID-19 broke out in 2020, the economy went down considerably pulling the stock market down.

Real rates or interest rate movements

Real rates or interest rate movements are also one of the crucial factors for making investment decisions. When the interest rate increases from the central bank’s end, borrowing of loans becomes costlier. And, hence, the spending capacity of businesses or traders can be impacted.

The lessened down spending capacity leads to lesser investments. Similarly, with a decrease in the interest rate, the spending capacity increases as the traders or businesses can borrow more leading to increased investments. For instance, Dow dropped significantly in March 2020 as the Fed had cut rates to near zero amid the global coronavirus pandemic.

Inflation or changes in prices

Inflation or changes in prices impacts the economy significantly since a high inflation reduces the capacity that each unit of currency can buy. Also, this means much lesser capital available with the public and an increased interest rate. Hence, the borrowing cost goes up leading to lesser investments.

Although, the value of financial assets increases with a rise in inflation. Some investors use the “high inflation” as a positive factor for investment since they believe that the underlying asset’s price may increase in future. This positive speculation leads to increase in volatility in the market.

For instance, the inflation rate in India grew by 2.9% in 2020 as compared to 2019. In 2019, the boom of the stock market took place with a lesser inflation rate as Apple was up 85% and Microsoft was up 15%.

Style factors or characteristics

Style factors or characteristics help to explain returns and risks within asset classes. Here are some examples of style factors:

Value

Value is a stock that aims to catch hold of excess returns from stocks that are priced low as compared to their fundamental value. The value stock is most commonly tracked using price to earnings ratio, dividends and the quantity of free cash flows.

For example, Citigroup has a P/E ratio of 9.67 compared to 19.12 for the average S&P 500 company.

Minimum volatility

Minimum volatility implies that the stocks with less volatility earn higher risk adjusted returns as compared to the stocks with high volatility. Hence, the asset with minimum volatility as a factor is considered good for investment.

For instance, Hindustan Unilever, Colgate, Invesco are some of the low volatility stocks currently.

Momentum

Momentum is another important factor that implies that the stocks or financial assets that have outperformed in the past tend to continue performing well in future. The momentum trading strategies usually performs for a few months to one year.

For example, by applying a long short strategy using Python code and Blueshift, the strategy returns are shown as follows:

The image above shows how the long short strategy outperformed the benchmark. You can see the strategy coded in Python with the detailed explanation in our blog on Momentum trading strategies.

How does factor investing differ from smart beta?

Smart beta is a subset of factor investing. The strategies are most commonly used in an ETF, are long only and are index based.

Smart beta, like factor investing, is a mix of passive and active investment strategies and below you can see what makes smart beta a combination of passive and active:

Also, the smart beta includes the strategies that usually refer to the style factors within a single asset class (bonds, commodities, cash and cash equivalent etc.).

Let us see clearly with the table below as to how factor investing and smart beta differ yet are similar with regard to the style factors:

Pros of factor investing

Since factor investing involves investing on the basis of factors determining returns and risks, there are several advantages attached to this type of investing. These pros are:

• Improved outcomes of portfolio
• Reduced volatility and
• Increased diversification of the investment

Factor investing finds out the risks over returns in each of the factors involved while trading. The factor based analysis helps with an improved portfolio outcome, reduced volatility risks and increased diversification of portfolio investment.

Cons of factor investing

Factors are not completely risk free and not being aware of these risks can lead to under preparedness in the trading journey. First and foremost, one must take into account how sometimes a factor may be seen only from the perspective of benefits in return and not the errors associated with it.

For example, a stock’s performance might have been good over the past two years in case of momentum. But, it is also possible that the stock had been seeing a downfall for more than 6-7 years earlier.

Before deciding your investment approach, you must weigh both the benefits and the errors it may lead to. After weighing both, you can get a near to accurate estimate of risks and returns of investing on the basis of that factor.

And perhaps most dangerous of all, factor investing presents the risk of data mining. Only factors that show good backtest results are shown. This bias is known as selection bias. A factor’s historical record being randomly good/accurate can lead to wrong decision making.

Conclusion

We discussed in this article how factor investing is a simple yet beneficial concept for financial market traders. It helps gain the necessary knowledge required to assess the returns over risks for an investment strategy.

There is a slight yet significant difference between factor investing and smart beta. In the end, we also discussed the advantages and disadvantages of factors.

If you're looking for smarter ways to manage risks and complexity, factor-based methods could be valuable. And, you can learn all about it in this factor investing course named, "Factor Investing: Concepts and Strategies".

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