Research conducted throughout the years has identified a number of different factors that play a role in expected returns. When investors structure their portfolio based on these specific factors, they can begin seeing better-than-expected returns. This is known as factor investing.
In recent times, we have considered the investment world to be made up of asset classes which would include the likes of bonds and equities. However, factor investing takes a different approach and is driven by an understanding of what factors influence risk and return. Certain factors might relate to an asset class directly while a combination of factors might play a role in other asset classes.
The aim of factor investing is to increase diversification, create returns that are above-market and help to manage risk more effectively. Investors have created a safety net by opting for portfolio diversification. However, any gains are lost, should the securities move together with the wider market.
The Drivers of Investment Returns
With this in mind, what are the “critical factors” considered in factor investing?
Value – This aims to take advantage of excess returns from low-priced stocks in relation to their fundamental value. This approach tracks price to book, dividends, free cash flow and price to earnings.
Size – Commonly, it has been seen that portfolios that have small-cap stocks will generate better returns than those portfolios that consist of large-cap stocks only. Through analysing the market capitalisation of a stock, investors can capture size.
Momentum – Based on historical evidence, stocks that have previously outperformed often show strong returns in the future. This strategy is implemented over a time frame of three months to one year.
Quality – Consistent growth in assets, steady earnings, low debt and solid corporate governance all define quality. It’s possible for investors to use common financial metrics such as debt to equity or return to equity to identify quality stocks.
Volatility – Based on empirical evidence, stocks that have low volatility could see higher risk-adjusted returns than those assets that are considered volatile. A method of capturing this is by measuring the standard deviation between a period of one year to three years.
Do you want to learn more about factor investing and evidence-based investing and how you could benefit from it? At Pyrmont Wealth Management, we believe in having an evidence-based investment strategy rooted on years of research and a pragmatic, life-centred approach to your finances.
Contact us today to learn more about evidence-based investing and discuss how we can set the right investment strategy for you.
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