Mastering Factor Investing

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By Jacob Maslow

Factor investing is now gaining prominence. It is an investment strategy in which securities are based on characteristics that are typically associated with higher returns. These pre-determined characteristics may include market capitalization, value and momentum. Through factor investing, indexes are constructed according to characteristics, allowing for a transparent, simple, and low cost method of indexing. Many investors see this strategy as a way to “beat the market.”

There are the five primary characteristics, or factors, that are currently considered factor investing.

1.     Momentum

Despite criticism, momentum’s outperformance in 2015 is impressive. Studies show that, in the short-term, recent performance will continue to persist. Stocks that have been outperforming over the last 6-12 months will likely continue to outperform for at least the next several months. Stocks that are underperforming will likely continue to lag behind.

2.     Value

Value investing is based on one key principle: stocks that have low valuations will beat those with high valuations in time.

According to data from Morningstar, the least expensive 30% of large to mid-cap stocks have outperformed the most expensive 30% of stocks by roughly 2.5% annualized from 1928 to 2015.

Today, investors use the price-earnings ratio and the price-to-book ratio to assess value.

3.     Low Volatility

Typically, stocks with less-volatile share prices will deliver higher returns in the long run. This is a mantra that does not sit well with most modern investors. After all, the more volatile, or risky, a stock is, the higher the returns it delivers. Yet, academics and analysts have all confirmed this effect is real and applies to any market around the globe.

Despite this, the low-volatility ETFs in the U.S. have not exhibited any outperformance versus the S&P 500.

4.     Small-Cap Effect

Academics have been studying small-cap effect for decades. The theory is that smaller stocks outperform large-cap stocks in the long run.

This may be true, but there are some caveats. Small caps offer higher returns but at the cost of higher risk. At times, small caps can underperform broader markets for long periods of time.

That said, if you are looking to maximize your long-term returns, the ideal choice is small-cap stocks.

5.     Quality

The least surprising factor is quality. Naturally, higher quality stocks perform better than low quality stocks. What makes a stock high-quality? Factors like stability burdens, low debt levels, and high equity returns are all things that should be considered when deciding whether a stock is high-quality. Over the last five years, high quality stocks have outperformed the S&P 500.

The market can be fickle, which is why no strategy will work every year. Studies suggest that in the long run, stocks that have these five factors will consistently beat the broader market.


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