InvestorQ : Can you tell me about some of the key factors that go into factor investing from an investor’s perspective?
Mary Joseph made post

Can you tell me about some of the key factors that go into factor investing from an investor’s perspective?

sara Kunju answered.
2 years ago

There are a variety of such factors that go into factor based investing. However, if we were to distil them we can probably combine them into five such categories. Let us look at each of these factors in detail.

Size as a Factor:

Small-cap stocks are typically more volatile and have a higher risk of bankruptcy than large-cap stocks. Investors expect to be compensated for tolerating this additional risk. As a result, small-cap stocks have outperformed large-cap stocks over longer periods of time. This has been seen in India also in the last 3 to 4 years although the period post 2018 has been slightly tricky for these small and mid caps.

Valuation as a factor:

Earnings drive valuations and hence inexpensive stocks should outperform stocks with rich valuations. When cheaper stocks report higher-than-expected earnings, they outperform due to improved optimism about a company’s future earnings potential. There are other ways to define value beyond earnings per share, including cash flows and earnings yield.

Momentum as a factor:

When it comes to returns, nothing really beats momentum. Stocks that have outperformed in the medium term often continue to perform going ahead too. These trends are based on the argument that a stock will catch investors' attention only after it has outperformed for a while. Only then will more investors pile into a trade and propel it even higher. One common way to measure momentum is to classify stocks by 12-month price returns.

Quality as a factor:

Quality can be both measurable and intangible. For a company to maintain higher profit margins than its competitors, it needs to have some type of a competitive advantage. This could be a superior product, better customer service, or a lower cost structure. Stocks of high-quality companies that generate superior return on equity.

Stability as a factor:

We can measure stability in the form of low volatility. The primary objective of the low volatility factor is to achieve higher risk-adjusted returns. Normally, low-volatility portfolios outperform the broader market over time and provide a smoother ride along the way. Such stocks with stable earnings models are also less susceptible to shocks.

Let us now get back to the core of factor based investing. Bu understanding factors that drive equity returns you can choose the right mix of investments for your goals and risk tolerance. Again, you need to give time for factors to work. For example, small-cap stocks underperform in volatile times; momentum can be disrupted for long periods and low quality may outperform high quality in the early parts of the economic cycle. These are some of the risks to the factor based investing approach.