Factor investing has seen massive growth recently. It is starting to be used a lot by professional investors but is still very much underutilized by retail investors. As I see it, factor investing is pretty much the most overlooked and important concept in investing.
In this article, I will give an overview of factor investing and delve into the history going back to 1960 of this fascinating area. We will explore each factor in depth and how each factor has performed historically. I will give you a list of high-performing factor-based strategies. Finally we will delve into how you can use factor investing to significantly level-up your investing!
I’m Shane; algo-investor, FIRE enthusiast, and the founder of Aikido finance.
Let’s dive in!
What is factor investing?
Factor investing is Evidence Based Investing or rules based investing. It is a method of choosing securities based on attributes that historically have been associated with higher returns.
Some of the benefits of factor investing include:
- Enhanced diversification
- Alpha above market returns (aka market outperformance)
- Manage risk
Factor investing flies in the face of efficient market hypothesis. Efficient market hypothesis is a very old, but very widely accepted idea that you can’t beat the market, it’s impossible, there is no information you could possibly have as an investor that hasn’t already been priced into the security. Factor investing proves the hypothesis wrong.
Indeed, you very much can beat the market, it is possible.
Types Of Factor Investing
There are two types of primary factors. There’s macroeconomic factors. And there are style factors.
Macroeconomic factors include a fiscal or geopolitical event, that affects the regional, national or even global economy. For example the GDP growth of a country, the unemployment rate, the printing of money, or even an unforeseen event, a black swan event, like a tsunami, an earthquake, or covid.
While these can all have big effects on the stock market; they are usually really, really hard to to predict, and even more so to know how they’re going to affect economies in general. That’s really because there’s just not a huge amount of data out there on how a tsunami for instance, effects an economy.
The most famous macro economic factor investor is Ray Dalio, who was the founder of Bridgewater.
I’m a huge fan of Ray Dalio. He’s very much an expert in the field of macroeconomic factor investing. Check out his most recent video here.
Without going into too much detail on macroeconomics, here are some of the big macroeconomic factors that we could look at:
Style factors, unlike macroeconomic factors, are very accessible to retail investors. Generally speaking, there are six broadly accepted factors.
The six factors are:
We’re going to go pretty deep on each of these six.
But there’s actually potentially hundreds, if not 1000s, of teeny tiny factors that are not broadly accepted or understood. MSCI actually utilize eight factors; they also include growth and liquidity.
But the six factors I mentioned above account for 95% of market outperformance and are easiest for retail investors to utilize.
The History Of Factor Investing
Check out this blog for a detailed account of the history of factor investing.
Modern Portfolio Theory
Factor investing started all the way back in the 1960s. It was built on modern portfolio theory. The project that Harry Markowitz won a Nobel Prize for.
It shows that there’s a direct correlation between the amount of risk you take and the return you can expect to receive.
In the 1960s, CAPM (Capital Asset Pricing Model) was introduced. In a nutshell, it declares that the higher the risk, the higher the expected return, it takes into account the risk free rate, which is normally the 10 year US treasury bill.
“The higher the risk, the higher the expected return”
This was the very start; where factor investing began. From there things started to get very interesting.
Three Factor Model
In 1992, Eugene Fama and Kenneth French came up with the three factor model to much critical acclaim. They looked at more factors, adding the size factor and the value factor. They found that small companies tend to outperform larger companies. And they found that cheap stocks tend to outperform overvalued stocks.
“Buy small, cheap stocks.”
Now, at this point in time, some investors had already been using this style of investing. Warren Buffett and Ben Graham had already been at it for decades with their value investing, but neither had modeled and proven it out.
The Fama French three factor model is very famous indeed and was a huge improvement on CAPM for explaining investment returns.
Four Factor Model
After Fama French’s work, a four factor model was introduced in 1997 by Mark Carhart. The Carhart four factor model added something really interesting: Momentum. Momentum is essentially technical analysis. It plays on the idea of investment psychology.
Momentum states that: stocks which have gone up recently tend to continue going up.
So in a nutshell, the four factor model states:
“Buy small cheap stocks that are on the rise”
Five Factor Model
In 2015, Fama French were back again.
Those smart folk decided to add two additional factors: Quality (profitability) and Growth (reinvest earnings).
“Buy small, cheap stocks, with high profitability, which reinvest earnings.”
Interestingly, Fama French didn’t add momentum to this model. And this fact was called out by Cliff Asness, the founder of AQR. Cliff argued for a six factor model, which included momentum. So the six factor model is now widely accepted.
The factors of the future
But it doesn’t really stop there. As I mentioned, there are potentially 1000s of teeny tiny factors, which is where alpha is generated – that is uncorrelated market performance. This is where things get super interesting, because if you’re a super high tech quant firm, you might be using ML (machine learning) to find these factors that most investors have no idea about. Indeed, you probably can’t even explain them verbally and they can only be understood by computers.
But really for almost everybody – you should just concentrate on those main factors. As I mentioned, 95% of market outperformance is accounted for by those factors.
The Massive Growth Of Factor Investing
Here’s some stats for you:
- 6 out of 10 of the top performing hedge funds are quant firms.
- Renaissance’s Medallion quant fund is famed for the best track record on Wall Street, returning more than 66 percent annualized ex-fees over a 30-year span from 1988 to 2018.
- On a typical trading day 90% of trades are made by computers.
- Blackrock estimate the Factor industry to grow to $3.4T by 2022.
And, here’s some more stats for you from SIG:
- Factor investing has grown at 30% year over year over the past decade.
- 80% of fund managers expect institutional investors to increase their allocations to quant strategies
- 86% of hedge fund managers expect the number of quant fund managers to increase over the next 5 years
Today, factor investing is largely being adopted through the medium of smart beta ETFs. These ETFs contain a large basket of stocks that target a specific factor – eg. value. However it could be adopted to a far greater extent, and give new life to active fund managers and investors – providing a structured way to beat the market.
So, as I mentioned, there is no efficient market. It’s pretty efficient, but it’s not 100% efficient. Stocks don’t follow a random walk, they take purposeful strides in the direction of factors.
A Factor Deep Dive
Value is the best known of the investment factors. It aims to capture excess returns from stocks that have low prices, relative to their fundamental value. This is famously how Warren Buffett and Ben Graham have invested for decades.
You can think of this like discount or bargain shopping. The aim is to buy a stock when it is priced well below its actual worth.
I have a friend called Liam – we lived together in Canada years ago – both of us are very big into the outdoors. Back then Liam would go into thrift shops and check out the outdoor gear they had on sale – jackets, pants, bags, etc. Occasionally he would find gear that was on sale for just a few bucks, but he knew that he could sell it on for many multiples more. It was mispriced. He did very well out of this flipping. He had excellent domain knowledge and a good eye for value. He was buying at a discount from its fundamental value. That is value investing.
The above graph shows the backtested returns of the Value factor (specifically the price-to-earnings ratio) since 1965 – yearly rebalance. The universe is split by decile, with the 10% most undervalued stocks (lowest P/E) on the far left, and the 10% most overvalued (highest P/E) on the far right. As we can see there is a wonderful linear correlation between value and returns. The most undervalued stocks far outperform the most overvalued stocks in the long term.
A Rough Checklist For Value
🮮 Price / Earnings < 15.0
🮮 Price / Book Value < 1.5
🮮 Price / Sales < 1.5
🮮 Price / FCF < 15.0
🮮 PEG < 1.0
🮮 Price / TBV < 0.7
🮮 Price / NCAV < 1
🮮 EV / EBITDA < 8.0
🮮 Current P/E is <40% of 5yr P/E High
🮮 Current P/E is <80% of 5yr P/E Low
🮮 Margin of safety below Intrinsic value > 30%
🮮 Intrinsic Value / current price < 0.7
Value traditionally performs best during economic recovery – just coming out of the dip of a recession. For example, coming out of the covid dip, I was invested in the Microcap Momentum Strategy (Value, Size, Momentum), and it performed phenomenally well during this period.
If we recall from above, quality was added in Fama French’s five factor model. Quality aims to capture healthy, stable and consistent companies with strong corporate governance. You can think of this like boutique shopping – basically, shopping for really high quality stuff that’s going to survive and last.
The above graph shows the backtested returns of the Quality factor (specifically the Return-on-Equity ratio) since 1965. The highest quality stocks far outperform the lowest quality stocks in the long term.
Warren Buffett was historically a deep value investor – starting out with cigar butt investing (finding “Net-Nets” using the NCAV metric). However as Berkshire Hathaway grew, Buffett added the quality factor to his stock picking methodology. He then became a quality and a value investor. Of course, back then Buffett had no idea what factor investing was – and yet unbeknownst to him, he was investing using this very structured and scientific approach.
A Rough Checklist For Quality
🮮 ROE > 30%
🮮 ROA > 15%
🮮 ROTA > 20%
🮮 ROIC > 20%
🮮 ROCE > 20%
🮮 ROIC-WACC > 0.2
🮮 Inventory Turnover > 4.0
🮮 Accounts Payable Turnover > 3.0
🮮 Accounts Receivable Turnover > 5.0
🮮 Pre-tax Margin > 15%
🮮 Free Cash Flow Margin > 10%
🮮 Current Ratio > 1
🮮 Quick Ratio > 1.5
🮮 Flow Ratio < 1.25
🮮 Liabilities / Equity < 0.8
🮮 Debt / Equity < 0.5
🮮 Debt / EBITDA < 4.0
🮮 Debt / TBV < 0.7
🮮 EBIT / Assets > 20%
🮮 Debt / NCAV < 2.0
🮮 Long-term Debt / Working Capital < 2.0
🮮 Interest Coverage Ratio > 8.0
🮮 FCF / Sales > 8%
Quality has historically performed best at the tail end of economic contraction (ie. in a recession)
Momentum is the use of techicals. Things get exciting here. The momentum factor indicates that stocks which have outperformed in the recent past tend to exhibit strong returns going forward. You can think of this as trend shopping – like buying Gucci because everybody’s talking about Gucci, and for not much other reason. You’re only doing it because everybody else is doing it.
Momentum is fascinating because plays on the psychology of investing – the emotional side which is so intrinsically linked.
The above graph shows the backtested returns of Momentum (specifically the 6 month relative strength; price increase) since 1965. The highest momentum stocks far outperform the lowest momentum stocks in the long term. Momentum is a very powerful indicator.
A Rough Checklist For Momentum
🮮 Positive 1-month relative strength
🮮 Positive 3-month relative strength
🮮 Positive 6-month relative strength
🮮 Positive 1-year relative strength
🮮 SMA 50 > SMA 200
🮮 EMA 12 > EMA 26
🮮 RSI < 30
🮮 Positive HMA
There are an abundance of metrics we could look at for momentum – but as always is is best to keep it simple (Occam’s razor). Relative strength will be perfectly adequate for most investors.
Momentum generally performs best during expansion – in particular, immediately post-recession.
The Size factor is very simple. Small cap stocks perform better than large cap stocks (market capitalization). You can think of this like niche shopping – you probably won’t have even heard of these stocks because they’re so small. But they tend to perform pretty well. The correlation is not as strong as Value or momentum, but it exists nonetheless.
It is worth noting that the lion’s share of gains come from the sub 25M market cap. That’s super nano cap. This is where retail investors like you and like me have a really big advantage over institutional investors. Institutional investors cannot touch those companies or they would buy them outright, which they don’t want.
Size has historically performed best during the early stages of economic recovery – during early expansion.
Stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. You can think of this like “safe shopping” – not buying anything too outrageous.
The low volatility factor has historically performed best during economic contraction / slow-down – ie. going into a trough.
Dividend is an honorable mention and not always included as a factor. Dividend paying stocks tend to yield better overall returns for investors. You can think of this like passive-income shopping, perhaps like purchasing a rental property.
The above graph shows the backtested returns of Dividend Yield since 1965. Higher dividend stocks slightly outperform the lowest dividend stocks in the long term.
Another powerful Dividend indicator you can use is shareholder yield which has superior backtested results to dividend yield alone; it also takes share buybacks into account.
Which Investment Factors Should I Use?
Above is the performance of MSCI’s factor-weighted ETFs over the past 20 years. Momentum and Quality have been the two factors which have performed the best – this is unsurprising given the vast quantity of money that has flowed into the S&P500 index over the past two decades – essentially a Momentum and Quality index.
Just like stock prices, factors improve and deteriorate over time. Factors exhibit momentum. AQR Capital’s “Factor Momentum Everywhere” was named “Best Article” in the 2020 Bernstein Fabozzi/Jacobs Levy Awards.
Blackrock found that Value and size performed best during recovery, Momentum performed best during expansion, and Quality and Volatility were best during slowdown and contraction.
O’Shaughnessy Asset Management found that Value and Momentum performed best during pre-recession, Dividend performed best during recession, Dividend and Value performed best post-recession, and Momentum and Dividend performed best during pure expansion.
As you can see, different firms make similar findings when it comes to factor performance – though each has their own subtle take.
This Is The Best Way To Determine Which Factor To Use
Rather than trying to guess which factor to use based on graphs, it is better to setup running paper portfolios based on different factors. Check in periodically with these paper portfolios to get a “lay of the land”; which factors seem to be performing best? This way you can easily switch your strategy using a logical approach when needs be.
For example, above is the performance of 16 seperate paper portfolios I set up targeting 16 different factor investing strategies – the performance is a one week period between Feb 23rd – Mar 1st 2022. At the point in time of writing this, the Value factor has been absolutely killing it over the past month (since the Ukraine crisis kicked off) – every Value portfolio is up over 10% in that time.
If you don’t want to setup the portfolios yourself, you can subscribe to the Aikido Newsletter – I send out weekly updates of which factor is performing best right now, so you can make the most informed decisions when investing.
Where To Find Factor Investing Strategies
The above strategy Trending Small Stocks, Good Value is the highest ranked factor investing strategy in the top ten factor-based strategy countdown. It is a multi-factor model that utilizes Size, Value, and Momentum.
How To Automate The Process
Creating a factor-based portfolio can be tiring work. It can take hundreds of hours to do properly and require a high level of skill. If you want to automate the process of creating a factor investment portfolio, you might be interested in Aikido Finance. Here’s how it works:
- Connect your crypto or stock broker to Aikido
- Pick a factor investing strategy
- Build a portfolio & the trades are sent to your broker.
Until next time,
Take it easy,