Factor Investing and Its 5 Components You Need to Know

Factor Investing & Its 5 Components You Need to Know

Factor investing is an investment method that uses specific drivers to determine the purchase of stocks. There are two types of factor investing: macroeconomic factors and style factors.

What is Factor Investing?

Factor investing, we also call beta investing is a strategy that chooses securities based on certain factors in order to get higher returns. There are two primary type factors that can determine high returns of securities:  macroeconomic factors and style factors. Macroeconomic factors capture broad risks across asset classes such as interest rates, inflation, and credit risk. While style factors include five investment factors: size, value, quality, momentum, and volatility.

Macroeconomic Factors

Events and conditions that widely affect the economy and seek to capture the risk across asset classes are macroeconomic factors. These effects can be natural, fiscal, or geopolitical. These events can have an influence on regions, nations, or the world.

Some examples of macroeconomic factors:

  • High inflation
  • Unemployment rates
  • GDP
  • Interest rates

Macroeconomic and microeconomic factors are completely contrary to each other; whereby microeconomic factors include stock price volatility and liquidity.

Style Factors

Within asset classes, style factors attempt to explain returns and risk. When analyzing securities, investors take into account five style factors:

  1. Size
  2. Value
  3. Quality
  4. Momentum
  5. Risk volatility

5 Factor Investing Components

The five-sector investing components are related to the factor investing style type. To give themselves the best opportunity of outperforming in the stock market, investors should pick assets that pass the criteria in each category.

1. Size

The size of the company is the first style factor you should look for in investing. There is a saying that a small company beats a large company. Companies with a market value of less than $2 billion are classified as small-cap. Small-cap stocks consistently outperform large-cap stocks in terms of returns.

2. Value

According to the value style factor, undervalued companies outperform overvalued companies. This suggests that the company’s stock price ignores potential growth or is undervalued in comparison to its underlying value. The price to book value ratio, price to earnings ratio, dividends, and free cash flow can all be used to determine a stock’s value.

3. Quality

Everyone has their own standard of quality. For some, it’s all about the return on investment. Profitability is important to certain people. Others are concerned about the actual quality of earnings when compared to cash flow. 

Because quality tends to last over time, it outperforms. If you’ve managed to maintain high profitability while growing your company to a billion-dollar-plus revenue level, you almost certainly have a competitive advantage.

4. Momentum

According to the momentum style factor, investors should be looking for stocks that have been performing well recently. When you look at recent success in terms of momentum, you should consider a three-month to one-year time frame.

5. Risk Volatility

Riskiness is measured using volatility as a criterion. Because they are less risky, lower-volatility stocks outperform over time. Many investors will diversify using the low-volatility factor. In down markets, low volatility tends to outperform, therefore if you invest based on the tiny component (which is riskier), you can still outperform with the low-vol factor.

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