Factor Investing – Benefits, Types & Features Explained:

Everything you need to know about Factor Investing

Introduction:

It is a method that selects securities based on their ability to generate higher returns. Macroeconomic indicators and style considerations are the two main categories of elements that have driven stock, bond, and other returns. The first one looks at risk across all asset classes, while the second one looks at returns and risk within each asset class.

The rate of inflation, GDP growth, and the rate of unemployment are all macroeconomic variables. Microeconomics: factors that affect a company’s creditworthiness, share liquidity, and stock market volatility are called microeconomics. All of these characteristics are considered when determining if a stock is a growth or value stock.

Types of Factors:

There are two main types of factors that have driven returns: macroeconomic factors, which capture broad risks across asset classes; and style factors, which help to explain returns and risk within asset classes.

Macroeconomic Factors:

These include broader risks in different asset classes like economic growth, inflation rates, liquidity, etc.

Economic Growth

A country’s Economic Growth has an impact on the companies existing in the country. Factors like growth vs. value, market size, credit rating, and stock price volatility have been identified by investors as important. To put it another way, smart beta is a popular application of the factor investing approach.

It is an investment technique and style that aims to grow an investor’s money. Growth investors tend to be interested in young or small companies that are expected to grow faster than average compared to their industry or the market as a whole.

Real Rates

Earnings and stock prices are adversely affected when interest rates rise (with the exception of the financial sector). Because the discount rate for future cash flow is higher when interest rates are higher, future discounted valuations will be lower.

Rising interest rates have a negative impact on the performance of stocks in general. Individuals might expect a larger return on their savings if interest rates rise. Eliminating the need for people to take on additional risk by investing in stocks, reduces the demand for stocks.

Inflation

A rise in inflation can have a negative impact on the economy as well as on individual individuals’ wallets. When inflation is strong, growth equities outperform value stocks and vice versa. When inflation is high, the stock market tends to be more volatile.

You are seeking to outpace inflation by investing in the stock market. The purchasing power of your money decreases when you don’t invest, so your investments should rise to keep up with the rising costs.

Credit

Investors and institutions can purchase debt assets, such as bonds, on the credit market. Governments and corporations raise money by issuing debt instruments, which take money from investors now and pay interest until the principal is repaid at maturity.

As a result, investors are willing to pay a higher interest rate for a credit risk premium. The default rate on corporate debt is far greater than the default rate on government debt. As a result, debt is paid to bondholders before equity investors are taken into consideration.

Emerging Markets

It’s an economy that’s in the process of becoming more developed. A common currency, stock market, and banking system are common in emerging market economies; they are in the process of industrialization. Investors in emerging markets should expect higher returns because of their rapid expansion.

There are certain similarities between a developing market and a developed market, but they are not identical. This also includes markets that might develop in the future or might not.

Liquidity

Liquidity in a market refers to the ability of a buyer or seller to buy or sell a product rapidly and without significantly altering the price. The price at which an asset may be sold and the speed at which it can be sold are two aspects of liquidity.

Style Factors:

These include risks specific to the asset class like volatility, momentum, value, etc.

Value

Value investing means buying stocks that seem to be undervalued based on fundamental research.

Stocks that are trading for less than their intrinsic value are what you’re looking for when using value as a criterion. It is possible to make a lot of money if the stock price rises to the point where it matches its intrinsic value.

Minimum Volatility

Volatility is a term used to describe the degree of fluctuation in a price series over time, and it is often calculated using the logarithmic standard deviation of returns. A time series of prior market values are used to measure historic volatility.

Some investors believe that stocks with low volatility can earn higher risk-adjusted returns than those with higher volatility. Traders look for equities that have a high degree of price volatility.

Momentum

Momentum investing is a strategy that focuses on purchasing and selling stocks and other securities that have shown strong returns over the past three to twelve months.

This is a crucial consideration for investors in order to select firms that have shown substantial recent growth. Investing in stocks that are doing well is appealing to some investors for a number of different reasons.

Quality

Investing in companies with high-quality features is the goal of quality investing, which uses a set of clearly defined basic criteria to find promising new investment opportunities.

Soft (e.g. managerial credibility) and hard criteria are used to evaluate the quality of the product (e.g. balance sheet stability). The best overall approach is supported by quality investing, not the best-in-class approach.

Size

We have 3 categories of companies. large-cap companies, mid-cap companies, and small-cap companies. There are three factors that determine a company’s size: its turnover, its balance sheet total, and its average number of employees. Additionally, qualitative characteristics are taken into account.

Carry

Income incentive to hold riskier securities. We tend to hold risky assets for higher returns if that allows us without affecting our financial obligations. Hence, taking risks is a choice we make.

Benefits of Factor Investing:

By using the concept of factors in the investment decision-making process, investors can boost returns, diversify their portfolios, and reduce the total risk of their holdings. 

Here are some of the benefits of Factor Investing:

Cost-Effective

Passive investment is the most cost-effective method of investing since it eliminates the need to research securities and select those that best meet your financial needs. Active investing is expensive due to the extensive study and analysis that is required.

It is more expensive than passive investing but less expensive than active investing to use factor investing. You can get better returns than passive investing and less volatility if you actively manage your risk.

Active-Passive Investing

Investors and fund managers throughout the world use both active and passive investing strategies. To engage in active investing, you must conduct thorough research before making any investment decisions. When you keep an eye on your investments, you can either buy or sell them as needed. When you don’t actively manage your money, you invest passively.

In factor investing, you get the best of both worlds. This is why choosing securities based on one factor but also keeping an eye on their performance and making adjustments if necessary, is a good idea.

Reduce Volatility

Investors use volatility to gauge the degree to which a stock’s price will deviate from its historical norm. The VIX, or Volatility Index, is a common metric for gauging market turbulence. Diversifying a portfolio is the most popular method for reducing volatility. Some investors prefer to keep their money in cash because it doesn’t move in lockstep with the stock market.

Based on a variety of characteristics, an investment portfolio will be less volatile and more diverse. Check to see whether there is little association between the variables you select.

Factor Investing V/S Traditional Investing:

Factor investing proves to be a better investment strategy on the following parameters:

Diversification

Making the portfolio more resilient is the goal of diversification according to underlying factors. Traditional methods of asset allocation, such as stock, bond, and private equity portfolio diversification, focus on a single asset class or area, while factor-based portfolio diversification takes a broader view.

If you’ve ever noticed, that when the stock market goes down, your entire portfolio is in the red as well. Putting all your eggs in one basket is the reason.

As a result, if one component isn’t functioning, another one might, saving you from the worst of a market decline.

Transparent

Traditional investing is less transparent than factor investing. You may not know why your investments aren’t doing as well as you’d want. The performance of factor-based funds is easy to explain because you know exactly why the fund performed so well.

Cost-Efficient

Investing in factors entails creating a set of guidelines and looking for appropriate possibilities. Because of this, the fund manager does not have to devote a lot of time to portfolio management. As a result, factor investing has lower transaction costs than other types of active investing.

Performance

Factor investing is based on a set of rules that allow investors to select companies based on specified characteristics.

Factor investing can be intimidating due to the sheer number of elements to consider, especially when compared to more standard portfolio allocations, such as a 60-40 stock/bond split. 

Factor investing beginners don’t have to worry about complicated concepts like momentum; instead, they just need to think about things like style (growth vs. value), size (big vs. small cap), and risk (beta). On the most popular stock research websites, these characteristics are readily available.

Passive Management

Human bias is one of the drawbacks of traditional investment. Decisions can be made in part by your own judgment. Even if the stock does well, you may wind up investing in a stock that doesn’t.

One argument in favor of using a mutual fund is that the fund manager is upfront about his or her investment strategy and objectives. We’re overlooking the fact that even money is managed by people.

Even the most well-intentioned boss is susceptible to prejudices. This problem is solved by factor investing, which doesn’t depend on human bias and only chooses stocks based on how they make sense.

Factor Investing- Everything you need to know

Conclusion:

The majority of active investors are forced to make an educated guess as to which way a stock’s price will go and then invest in accordance with that guess.Β 

As a result, judgments are made using data or metrics that show how a stock has performed in relation to particular aspects. Compared to active investment, factor investing is more evidence-based and dependable.

Fund managers use factor investing to select stocks based on specific characteristics. Stock returns are mostly determined by the presence of these characteristics.Β 

One of the advantages of factor investing is that it is objective, systematic, and clear. Factor investing helps when the usual way to invest is likely to lead to returns similar to the market, less diversity, and more risk.

If you invest in factors, you’re more likely to get a well-diversified portfolio with less risk and better returns.

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