Factor investing is an investment method that uses specific drivers to determine the purchase of stocks. There are two types of factors in 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 factor types 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:
- Inflation rates
- Unemployment rates
- GDP
- Interest rates
Macroeconomic and microeconomic factors focus on different aspects; 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:
- Size
- Value
- Quality
- Momentum
- Risk volatility
5 Factor Investing Components
The five-sector investing components are related to the style type of factor investing. 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. It is often suggested that smaller companies can provide higher growth potential. Companies with a market value of less than $2 billion are classified as small-cap.
2. Value
According to the value style factor, undervalued companies outperform overvalued companies. This suggests that the company’s stock price may not reflect potential growth or is undervalued in comparison to its intrinsic 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.
The quality factor suggests investing in companies with strong financials. This includes traits like profitability, low debt and stable asset growth. The quality factor helps to build resilience into the portfolio. 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 tend to outperform over time. Many investors 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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