Staff Reporter
By Peter Dougherty
‘Factor investing’ is the process of constructing an investment portfolio that contains groups of stocks (or other assets) with certain traits, such as being fast-growing, stable, or cheap. These traits have historically delivered* excess returns or reduced risk (or both) as compared with the market.
The factor investing framework has been gaining widespread popularity. A decade ago, nearly one half trillion dollars was invested via factor investing in the United States (if a half trillion is too difficult to conceptualize, think of it as ‘500,000 million dollars’). Today this market has expanded to more than 2 trillion dollars (or ‘2,000,000 million dollars’).
Academic research – that considers decades of portfolio experience – has identified common characteristics or ‘factors’ that help explain why some stocks might earn higher returns than others. Some of these factors include:
• Value: Buying undervalued securities that are cheap relative to a company’s financial fundamentals (e.g., low price-to-earnings ratio). Value investors believe every company has a true value (intrinsic value). When the market price of a company’s stock falls below this intrinsic value, investors can buy low and wait for the market to recognize its worth.
• Size: Favoring smaller companies, which historically outperform larger ones over the long run. The size of a company is defined by its market capitalization (total number of shares outstanding times the price per share). Large cap stocks (often defined as having a market cap of $10 billion or greater in the United States) are often safer but don’t typically exhibit the same growth as small cap stocks (defined as having a market cap between $300 million and $2 billion).
• Momentum: Investing in stocks that have recently performed well, based on the assumption that trends tend to continue. Momentum investing can be like surfing, where you try to ride the wave of recent successes, knowing you need to get off before it crashes.
• Quality: Focusing on companies with strong profitability, stable earnings, and low debt. It is a strategy that focuses on buying companies with strong financial health, regardless of their size and whether they are “cheap” (value) or have momentum. Good quality companies are more likely to deliver stable earnings and long-term success.
Factor investing is broader than selecting individual stocks because multiple stocks that share given factors are typically purchased. At the same time, it is narrower than index investing (which buys all the securities that comprise the index). Each factor has its own cycle of outperforming and underperforming the market.
Factor investors typically build balanced portfolios which they often tilt toward the factor(s) they believe will currently perform best. By combining factors, investors can smooth returns because different factors often have low correlation (i.e., they don’t all work at the same time). Much like eating at a buffet, a multifactor strategy investor may not equally enjoy everything on their plate but combined it makes a well-balanced meal.
*We all know that past performance is no guarantee of future results. However, if past performance provides no indication at all of how to invest for the future, researchers would be left with nothing to study. So, when it comes to factor investing, I need to choose my words carefully and say ‘delivered’ not ‘do deliver’ and under no circumstances can I say ‘will deliver’.
Peter Dougherty is a Financial Planner at BISSAN Wealth Management in Spain. He holds an MBA in finance from Columbia University in New York and an MS in Spanish taxation (Máster en Fiscalidad y Tributación) from Nebrija University in Spain. He is certified as a European Financial Planner (EFP) in Spain and as a Chartered Retirement Planning Counselor® and Investment Adviser Representative in the United States.
For more information: https://www.financial-planning-in-spain.com
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