Factor investing is based on finding stocks with certain common characteristics that can provide outperformance.
Starting in the 1980s, researchers started to uncover something very interesting. They found that stocks with certain common characteristics tended to, on average, provide higher returns. The most influential work published was the so-called Three Factor Model, by academics Eugene Fama and Kenneth French, in the early 1990s.
All this has given rise to so-called factor investing, part of ‘smart beta’ strategies.
A factor is a characteristic that certain stocks have, causing their prices to move together. Some of those factors have been shown to provide higher than average performance over certain periods of time.
There has been a flurry of research uncovering new factors, with many highly questionable findings. However, there are few widely accepted factors:
- Dividend yield
All these factors, and many more, can now be tracked by investors through so-called smart beta ETFs. These ETFs follow an index that screens for one or more of these factors, with the aim being that they outperform the wider market.
Below, we provide a brief overview of the main factors.
The value factor
Value is probably the most famous factor. So-called value stocks are those with cheap share prices. Cheap, of course, is subjective. However, there are several metrics to identify cheap/value stocks including price-to-book ratio, price-to-earnings, price-to-cash flow or price-to-sales. Many indices use a blend of metrics.
The good – it has historically paid to buy cheap stocks
Reams of academic literature show that value stocks outperform the market average over the long term. For example, one study by Eugene Fama and Kenneth French has shown that between 1975 and 1995 the average return of a global portfolio of low valuation stocks was 7.68% per year higher than that of a global portfolio of stocks with high valuations. Similar data exists for different periods of time and different specific country markets.
The bad – value may no longer work so well
The first potential downside of the value factor is that it has not worked very well lately. Over the past decade, value stocks have notably underperformed the wider market.
There are many theories attempting to explain this. Some posit that there are simply too many value investors now. Others argue that outdated accounting rules do not fully reflect the value of firms in the digital age. Others see it as cyclical and expect value stocks to return to favour soon – so far, those predictions have fallen flat.
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Another risk is that investors may end up being clustered in specific sectors. Companies in some sectors, such as energy or financials, tend to trade on lower valuations. As a result, investing in the value factor can mean being overweight these specific sectors.
The size factor
Size in this content means the market capitalisation of a company. That is, the price of a company’s shares multiplied by the number of shares in issuance. Smaller companies have smaller market capitalisations and tend to outperform larger companies.
The good - smaller stocks equal bigger returns
There is a lot of research showing that smaller companies provide better performance than average. This was one of the first factors to be uncovered and was included in the French and Fama Three Factor Model.
Smaller companies outperform for several reasons. First, being smaller, they can experience more rapid growth. Second, smaller companies are riskier. Financial theory says that riskier assets provide a higher return.
The bad – smaller stocks are more volatile and illiquid
Of course, that risk means that smaller companies are more volatile. This is particularly so when investors are nervous. When markets are falling, it is usually the case that smaller companies underperform larger companies.
Smaller company stocks are also more illiquid, meaning there are fewer buyers and sellers. This can make it difficult to buy or sell at the price you want. It is sometimes harder for smart beta ETFs to replicate small company factor strategies.
The momentum factor
The basic idea behind the momentum factor is that stocks that have shown strong performance in the past are likely to continue to do so in the near-term future.
This completely contradicts the old investment maxim, ‘buy low and sell high’. The approach sounds dangerous, but has been validated by a number of authoritative academic studies.
The good - what goes up, goes up some more
A 1993 paper entitled ‘Returns to buying winners and selling losers: implications for stock market efficiency’ by academic J. Titman, and published in the Journal of Finance, was one of the first studies to show that momentum stocks provided higher returns.
The momentum factor is often explained by the behavioural biases of investors – principally, people like to chase returns. If enough people chase returns, this can become self-fulfilling, pushing up prices.
The bad – momentum has a short time horizon
However, most stocks do not continue to outperform forever. Studies show that the momentum effect is strongest between three and 12 months.
This relatively short time horizon is one of the biggest downsides of the factor. If momentum stocks cease to be momentum stocks after a relatively short period of time, any investment strategy based on this factor will have to remove and add stocks quite often. This increases trading costs and eats into returns.
Other risks include being potentially overexposed to overvalued stocks, which can prove damaging if, or when, markets turn.
The quality factor
Quality stocks are those of companies with certain strong financial fundamentals. While there is no universal agreement, generally this includes companies with strong balance sheets, low debt, steady growth and seemingly sustainable profits.
The good – solid companies are more reliable
That companies deemed ‘quality’ outperform doesn’t sound that surprising. As noted in the book Beyond Smart Beta: Index Investment Strategies for Active Portfolio Management: “You don’t want a highly leveraged company that has a high variability in its earnings and growth rate. Investors seek companies that manage their capital carefully and reduce the risk of over-leveraging.”
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Quality stocks also tend to do better when the economic outlook is poor. In times of economic trouble, investors become prepared to pay higher prices for companies with sustainable earnings and low debt as they are expected to be more resilient and less likely to fail.
As well as usually providing higher returns, quality stocks are also less volatile.
The bad – lags in rising markets
Of course, if investors are prepared to pay a premium for quality in tough economic times, when sentiment is more bullish they are less prepared to pay this premium. As a result, quality stocks often lag in rising markets.
Another downside is that this factor has so many definitions that it can be difficult to implement.
The high dividend factor
Many do not think of ‘high dividends’ as a factor. But high dividends is a common trait and it is documented that historically these companies have provided a higher return than the market average.
The good – the power of compounding
The reason why high dividend-paying stocks outperform is quite simple: the compounding of dividend reinvestments. Over the long term, dividend reinvestment is where the vast majority of stock market total returns come from.
The bad – high yields can be value traps
However, one way to measure if a company has a high dividend is to compare it to its share price, known as the yield. While a company may have a high yield due to large dividend payments, it can also be because of a low share price.
If a dividend-paying stock has seen its share price fall, it may have a very high yield. However, the stock’s price will have fallen because the market sees it as a company with bad prospects. As a result, simply buying high-yield stocks can mean investors buying bad companies.
High-yielding stocks are often also found in specific and more mature sectors. Younger companies in faster-growing sectors are less likely to pay high dividends, as they reinvest more for expansion. As a result, a high dividend strategy can mean that an investor’s portfolio is focused on a cluster of mature companies in old and sometimes stagnant sectors.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
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