Q&A: What is factor investing?

We recently hosted Tim Edwards, Senior Director, Index Investment Strategy at S&P Dow Jones Indices, for an in-depth discussion about factor-based investing and the role it can play in a diversified portfolio.

Chris: What is factor investing? What are the factors?

Tim: To be a factor, two things in particular need to be true. The first is that it needs to be a characteristic of stocks that explains the differences between returns.  For example, a company’s size can often help explain their performance.  Size is a factor.  The second characteristic of a factor is that it is something that can be measured and captured.  For example, whether a stock is going to outperform would be very useful to know, but we don’t know which ones will do that.  So, that is not a factor.  The term “factor investing” really means investing in portfolios specifically designed to capture certain factors.

Chris: Factor investing is rooted in decades of research. Can you talk about some of the better-known factors, those that have shown persistence as consistent drivers of returns?

Tim: In markets across the world, lower-risk stocks have historically shown an improved risk/return profile, which has led to a wealth of research on the “low volatility” factor.  Perhaps even more famously, the value factor has accumulated close to a century’s worth of research and study.  Two more factors that are very commonly looked at include size – small companies tend to outperform large companies – and momentum, which is the concept of identifiable trends within individual equities, relative to each other and to the market.

Chris: Why have certain factors provided better risk-adjusted returns historically and how is this likely to persist in the future?

Tim: The outperformance of a few factors, I would identify low volatility, value and momentum in particular, has been the source of much academic and practitioner debate.   The long-term outperformance from these factors is, of course, a challenge to the efficient market theories preferred by academics.  For investors, the more pertinent question is whether they have the right exposures to these factors, and if the historical pattern of outperformance will continue.

Chris: What has the evolution of indexing meant for investors trying to seek factor returns or capture factor returns?

Tim: A good few decades ago, offering market-like returns was a highly rewarded activity. In time, managers’ performance began to be increasingly compared to broader market benchmarks. Then those same benchmarks became investible, at a relatively low cost, via the first index funds. Other strategies in the purview of active management eventually followed: value, risk management or momentum strategies became widely available in indices. As time passed, it became increasingly apparent that the core patterns of returns that many funds were offering were systematically replicable through a market exposure and a few select factor tilts. I see it as something of a democratization process, in which these forms of investing are examined, systematized, indexed and eventually made available to investors through index-linked investment products, typically at a much lower cost and with greater transparency.

Chris: In your mind is factor investing a free lunch? Is there a way for investors to know when to rotate between factors to end up with a better result than the market?

Tim: I would caution against a belief that any one of these, or any one combination of these, will deliver persistent constant outperformance. There’s no magic recipe that gives you the perfect solution over every time period, each of these factors will ultimately be affected by the macro environment.  Having said that, there is obviously the opportunity for investors to either diversify or better calibrate their exposure to factors either with the goal of a long-term outperformance, or better navigating the current environment.

Click here to access the full interview.

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