- Understanding factor-based investing in details
- Beginners in factor-based investing
- Macroeconomic factors to consider
- Style Factors to Consider
- Analysis of Important Macroeconomic Factors:
- Analysis of essential style factors
- The Fame French model
- Summed up- Benefits of factor-based Investing
- Challenges of Factor-based investing
- Fact-check before choosing partners for factor-based investing
- Choose your Best Factor Combination
Want Big Returns from Your Investments- Choose Factor-based Investing and Realize Your Real Investment Potential!!!
Factor-based investing is a high-return investment strategy. All factor funds guarantee high yields. So far, we know of two factors- macroeconomic and style factors if you want a high return from stocks, bonds, or other tractions.
The macro factors detect broad risks across the main asset classes. At the same time, style factors show the scope of return and risks within every asset class.
Some known macro factors are inflation rate, GDP growth, unemployment, etc. All such factors equally affect all asset classes. However, microeconomic factors are different. They may be your company’s credit, price fluctuations, or share liquidity.
When you are comparing growth vs value stocks, choose style factors. It would be easy to make a head-to-head comparison of the style factors of the two stocks. Meanwhile, you can also use style factors to assess an industry sector.
Understanding factor-based investing in details
Factor-based investing is designed to help you earn big. You can preferably earn higher than average returns when you consider factor-based investing. Meanwhile, factor investing can also help you to diversify your portfolio. It may draw a lot of alternative investments to your portfolio.
Well, most investors take to portfolio diversification. But you will get no gains from the diverse stocks if they end up in lockstep within the vast market. Let’s take an example for better understanding.
You choose a diverse portfolio of stocks and bonds. But the whole portfolio declines when market conditions go hayway. So, what’s the benefit of such a diversification? That’s where Factor-Based Investing comes in.
It offsets the main risks by targeting broad and persistent returns. It also tracks the patterns of maximum returns in recent times. When you follow the pattern, you can expect stable returns.
Beginners in factor-based investing
In most traditional portfolios, there are 60% stocks with 40% bonds, but that doesn’t work the same way with Factor-Based Investing. This traditional divide is pretty straightforward. However, Factor-Based Investing may seem complex, given the number of factors under macro and style factor clusters.
But here’s a trick beginners may try. They must overlook the complex factors for a start. For example, factors like momentum. Instead, they should invest in simpler factors like style (comparing growth vs value), size, risk, etc.
You will find these listed factors when you scan the major stock market websites.
Macroeconomic factors to consider
Consider these macroeconomic factors. But beginners do not need to go for all the factors. But it is crucial to know about all the factors:
Style Factors to Consider
Style factors analyze the risks mainly. So, beginners cannot ignore them while choosing asset classes:
Analysis of Important Macroeconomic Factors:
| Macroeconomic Factors | Analysis |
|---|---|
| Economic Growth | When an economy grows, people earn more. Hence, they spend more. Therefore, the companies earn more profits as well.Similarly, companies earn less when there is a downturn in the economy. |
| Inflation | When inflation hits, the purchasing trends change. People dread high price hikes. Hence, distributors start gatekeeping, and the public begins stocking essentials. Two years ago, it was vividly observed when the inflation rate reached 8.1%. However, the trends normalized when the inflation slumped to 4.1% in the last year. |
| Credit | Credit here refers to dividends in the form of compensation. You can earn compensation when you hold stocks that have default risks. |
| Interest rate changes | When rates increase, you will find it hard to borrow money. In return, it slows down the consumers’ spending. |
Analysis of essential style factors
| Style Factors | Analysis |
|---|---|
| Value | You may profit from buying an underpriced asset at the moment. But there is no certainty that its value will rise in the long run. However, we have fundamental analysis to predict the same. |
| Size | Let’s say you want to invest in a company with a $5 million annual turnover. Is it a good investment? I’d say YES if the company’s earnings have grown steadily in the last 5 years. In conclusion, small companies are always investible as they render better returns to investors. |
| Quality | Always invest in financially healthy companies. Especially check out the debt to value ratio of the company you aim for. Economically healthy companies have better returns on both assets and equities. |
| Momentum | Let’s consider stocks A and B. A is giving good returns, But it is not rising in value. Again, B is providing fair returns and also growing. Here, B is more investible. |
| Volatility | When a stock price doesn’t fluctuate much, it is highly investible. But beware of those with more fluctuation in a short period. |
The Fame French model
It is a gravely popular multi-factor model. However it uses the base of the capital asset pricing model. The model rests on 3 main factors:
- Size of companies
- Book-to-market values
- Excess market returns
The model also runs on three simple philosophies:
- SMB or mall minus big
- HML or high minus low
- Return from portfolio minus the risk-free return rate
We do SMB for the publicly traded companies. But those companies must have small market caps and still generate better returns. In comparison, the HML works for the value stocks. Again, the stocks with good book-to-market ratios will only qualify.
Summed up- Benefits of factor-based Investing
There are many benefits of factor-based investing. Firstly it helps you to diversify your portfolio, while making it risk-free. Most importantly, it reduces the risk exposure of your portfolio. Meanwhile, your portfolio’s stocks and funds also give better-than-average returns.
Fundamentally, the strategy analyzes the best traits of any stock. Hence, it helps you determine if that is investible or not. Therefore, I recommend investing in stocks after you’ve analyzed the factors well.
Challenges of Factor-based investing
There are many benefits of factor-based investing. But you must be aware of the risks of factor investing too. You need high-quality data from reliable sources to do a factor analysis. Often, you don’t have access to quality data. So, it may be challenging to pull off factor analysis.
When social or political instability strides, even returns after factor analysis may be misleading. Wait, there’s more.
In cases of currency exchange rate fluctuations, the investment value also swings. So much so far. But there could be further risks if you’re trading in an emerging market. For example, an unpredictable regulatory environment may cause investment values to depreciate. So, factors are as valuable as the market where you are trading. The factors that work well in developed markets might falter in an emerging market.
Fact-check before choosing partners for factor-based investing
Choose a factor investing partner who qualifies for the criteria below:
- Factor timing over time: shares insights from over a decade to determine that the factors are cyclical.
- A systematic framework for factor tilting: Follow a time-varying approach to detect the cyclical factors. In essence, individual factors may sometimes fail to perform as expected. For example, inflation hit the markets badly some time back. However, it never implies that you should sell your assets when a single factor underperforms. You stay put. Wait for the right time. For example, inflation has visibly dropped since last year. Now, your stocks will perform better.
- Style factor cycles in this century: check the latest journals to know about long- and short-term style factors. Shape your investments accordingly. Rely on the short-run factors if you are investing in the short term. And do likewise for the long term.
- Invest in the core fixed US market with both factors: create a balanced portfolio. Meanwhile, include the fixed income macro factor tilts and time-varying exposures.
- Factors and advisor portfolios: Don’t copy advisor portfolios. They will work for the short run only and do not guarantee success.
- Defensive Factor Timing: Leave it to your professional factor investing partner.
Choose your Best Factor Combination
Factor-based investing is a selection process. Here, attributes are linked to higher returns. Hence, you have to select the attributes in the right combination. There are two main sets of factors- macro and style factors.
Factor-based investing has many prominent benefits. Firstly, it diversifies your portfolio. Secondly, it reduces your investment risk to a great extent, too. Most importantly, it guarantees higher than basic returns.
Well, factor-based investing may be all gain and no loss. But it is certainly not risk-free. You can go up to check the risks and how to avoid them. Barring a few risks, factor investing is a sure winner. So, cut some slack. Book an ETF today. But run it through one or more factors.
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