The Factors

WHAT ARE FACTORS?

What are Factors in an Investment setting, OR What are Factors?

One might think of factors as features that one considers before making a purchase. Price, location, amenities, and safety are all common considerations when purchasing real estate. Similar to how consumers evaluate products, factor-based investors typically assess securities based on a number of characteristics (such as Quality, Value, Low Volatility, and Momentum), which are known as "Factors" in the investing world. Factor investing is the practice of making investment decisions, such as stock selection and asset allocation, solely on the basis of quantitative principles to gain exposure to certain factors.

Investing in factors: Active or Passive?

By copying the underlying stocks and their weights, passive investing aims to replicate a benchmark index (such as the Sensex 30 or the Nifty 50). Although it cannot outperform its underlying index, it does have the advantage of being intrinsically disciplined. Conventional active investing is, in contrast, mostly discretionary as fund managers select which stocks to buy. They offer the chance to outperform their benchmark index, but investment choices aren't governed by strict rules.

Factor investing combines the best qualities of both passive and active investment strategies by using rules to find stocks with desirable characteristics and build a portfolio that has the potential to outperform the benchmark index.

Factor Categories: Macroeconomic vs Style

Factor Categories

Most investors classify investment factors into two broad categories, namely macroeconomic and style factors.

As its name suggests, macroeconomic factors illustrate broad macroeconomic and financial elements of risk across several asset classes such as equities, fixed income, and gold. Common macroeconomic factors include interest rates, real GDP/economic growth, inflation, money supply and liquidity. Macroeconomic factors are typically used to determine asset allocation between different asset classes (Macroeconomic Factors: Important Diversifiers).

On the other hand, style factors are those specific to an asset class and used to select securities within the asset class. It is believed that a stock’s attributes such as its market capitalisation, earnings quality and overall financial health, returns’ volatility, market price relative to intrinsic value, and finally recent upward or downward trend tend to explain its long-term risk-adjusted returns. The most prevalent style factors for equities include size, quality, volatility, value, and momentum. We explore these in detail in the coming sections.

Download e-book