What is factor investing and how do I get started?

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CMC Invest

12 January 2024

Key points

  • You don’t have to deploy factor investing as a strategy, but many investors like to allocate to stocks that embody certain qualities in a bid to outperform the broader market.
  • Style factors refer to qualities that impact the risk/return profile of individual stocks. Macroeconomic factors have a broader impact across all stocks.
  • Proponents of factor investing say it can aid portfolio diversification and help manage overall risk.

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Important: This information is for guidance purposes and may become out of date at any given time. It is not investment advice. Investments can rise and fall in value. We won’t make any assessment of whether the investments you choose are appropriate or suitable for you. If you are unsure of the suitability of any investment, investment service or strategy, you should seek independent financial advice. Past performance is not a reliable indicator of future results. Capital is at risk.

What is factor investing?

Imagine you’re creating a perfect Spotify playlist. Depending on your tastes, you’ll browse through music and add what floats your boat. Maybe you want to include anything that’s a top 100 hit. Maybe you want to exclude anything in the death metal genre. At the end of the process, you’ve got a collection of songs that works for you.

Your playlist curating is a little bit like how factor investing works. Factor investing is a method of selecting stocks to invest in based upon the specific qualities ­– or factors – they have. These can be either positive or negative. Stocks with negative factors will usually be avoided (like those bloodcurdling death metal songs), and positive factors will be sought out.

When we talk about “factors” we’re referring to characteristics that stocks have. These may impact or indicate the potential return or risk of an investment.

Proponents of factor investing say it can aid portfolio diversification, risk-management and returns. Of course, no investment strategy is ever guaranteed to generate positive performance, even if it’s done so in the past.

There are multiple factors affecting an asset that can be considered when investing. Let’s take a closer look at some…

What are the different investment style factors?

Factors that potentially affect the risk and/or return profile of a stock are often referred to as style factors. These include:

Volatility: You’ve probably been warned that some investments are volatile – think cryptocurrencies, for example. When a stock has high volatility, it means it’s susceptible to unpredictable price moves. It may be way up one month and come crashing down the next.

You may also hear people refer to “high beta” stocks when they’re talking about volatility. This means the stock has a higher level of volatility than a particular market or index – like the S&P 500.

By contrast, low-volatility stocks tend to have more predictable returns and don’t see huge swings in their share prices.

Yield: A stock’s dividend yield is a measure of its paid dividends relative to its price. Let’s say two stocks pay 25p in dividends. One’s share price is £10 while the other can be snapped up for £2.50. The latter would have the higher dividend yield.

Quality: When investors talk about prioritising quality as a factor, they mean they’re putting a lot of importance in a company’s fundamental business metrics. For example, they may assess a company’s debt, its earnings stability, its earnings variability and its profitability. Putting these together will hint at a firm’s overall quality.

Momentum: Momentum investing involves finding stocks that have been on a roll. If a stock has been trending upwards for the last 12 months, then it may be seen as having strong momentum, attracting investment from people who put a lot of value in this factor.

On the flip side, if the general trend of a stock’s performance shows it’s falling over time, a momentum investor will likely sell it or avoid it.

Value: Everybody loves a bit of a bargain and investors are no different. Value investing involves purchasing stocks that are trading below what an investor thinks they’re worth. The goal is to pick up stocks when they’re “cheap” and sell them when they subsequently rise in value. It’s a very popular investing strategy.

To identify which stocks represent good value, people often look at ratios including the companies’ price-to-book and price-to-earnings.

Size: You may have heard people refer to “large-cap” or “small-cap” stocks previously. When people talk like this, they’re noting the size of any given company or group of companies.

Some investors believe the size of a company influences how its stock performs. The consensus is that larger companies provide smaller levels of upside but are more stable. Smaller firms, on the other hand, can generate large returns but come with a higher degree of risk.

Growth: A company’s growth over time and how that affects its performance is another factor investors often consider. Earnings and sales growth are key metrics in this category. It’s another factor that is very popular among investors.

Liquidity: Liquidity looks at how much trading volume a stock typically has. Stocks with high trading volumes are often turned to because they can be bought and sold easily. That means that if a there’s an opportunity to be had, it can be executed with the greatest ease.

What about macroeconomic factors?

There are also wider macroeconomic factors that affect most assets on a larger scale. Professional investors will often also take these into account in addition to the style factors listed above.

A stock may look to be of great value, but if economic conditions are weak, it may not perform well until these improve.

Here’s a list of some macroeconomic factors:

Economic growth: You’re probably familiar with reading about how a country’s GDP is growing or shrinking. This is a measure of economic growth – how a country is performing in terms of whether the economy is growing or shrinking.

Interest rates/inflation: Interest rates and inflation affect stock prices. Therefore, an outlook for these factors may be included in stock analysis and portfolio construction.

Geopolitical climate: The stability of the political situation in both domestic and international markets may also be considered by investors. War and instability affect how people spend money and invest. The geopolitical climate is, therefore, a factor that affects stocks and other assets on a wide scale.

Credit/financial: When people talk about credit or financial conditions, they are often referring to the financial health and lending risks within a country. This includes government default risk or high leverage and default risk across prominent sectors in the economy. All of these can impact the performance of investments.

What are the risks of factor investing?

Many of the world’s most renowned investors have turned to factor investing at one stage or another. It does, however, carry some risks.

In chasing one or two factors, investors may inadvertently hurt performance, increase risk or lower diversification. For example, an investor who focusing on larger companies (size factor) is ignoring a whole section of the market of small- and mid-cap stocks.

Additionally, factors can help give an indication of what the risk/return of an investment might be – but this isn’t guaranteed. How a stock performed in the past isn’t an indication of how it will perform in the future. At times theoretical returns for factors may be overstated and risks understated. 

How do I get started factor investing?

Once you’ve decided which factors you want to form part of your investment strategy, the next step is to identify assets that meet your desired criteria.

Sometimes, this might be straightforward. If you’ve decided you want to use size as a prominent factor, it’s not a huge task to see which stocks are large-cap and which are small or mid-cap.

Other factors are more complicated to figure out, however. For example, if you want to be a value investor, you’ll have to look into companies’ fundamentals and assess their key ratios relative to their peers and the broader market. That can be a lot of work and requires you know what you’re doing.

An alternative is seeking out an ETF that invests in an index consisting of stocks embodying various style factors. This way, you’re letting a professional assess the stocks while also diversifying across a pool of assets.

Is it for me?

You don’t have to deploy factor investing if it seems overwhelming. Many investors are content to invest in broad-based equity indexes and ride out the market over time.

Additionally, you don’t have to pick just one factor to focus on if you’re looking to get into factor investing.

Some investors deploy multi-factor strategies which, as the name suggests, attempt to focus on multiple factors at one time. A multi-factor strategy might involve finding large-cap stocks that also represent great value. Or you could seek out growth stocks that have attractive dividend yields.

Just make sure you do your own research and seek out independent help if you are unsure about the suitability of an investment.