Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Over the last 50 years, academic research has identified hundreds of factors that impact stock returns. Security characteristics that may be included in a factor-based approach includes size, value, momentum, asset growth, profitability, and leverage.
A factor-based investment strategy involves tilting equity portfolios towards and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.
History and evolution
The earliest theory of factor investing originated with a research paper by Stephen A. Ross in 1976 on Arbitrage Pricing Theory, which argued that security returns are best explained by multiple factors. Prior to this, the Capital Asset Pricing Model (CAPM), theorized by academics in the 1960s, held sway. CAPM held that there was one factor that was the driver of stock returns and that a stock’s expected return is proportional to its beta, or sensitivity to equity market returns.
In the following decades, academic research has identified more factors that impact stock returns. For example, in 1981 a paper by Rolf Banz established a size premium in stocks—that smaller company stocks outperform larger companies over long time periods.
In 1992, Eugene F. Fama and Kenneth B. French published a seminal paper that demonstrated a value premium, or the fact that expected returns of value stocks were higher than for growth stocks.
In 1993, Sheridan Titman and Narasimhan Jegadeesh showed that there was a premium for investing in high momentum stocks. Other significant factors that have been identified are measures of corporate profitability, asset growth, external financing, leverage and research and development costs.
The value factor
The earliest and most well-known factor is value, which can be defined primarily as change in the market valuation of earnings per share ("multiple expansion"), measured as the PE ratio. The opportunity to capitalize on the value factor arises from the fact that when stocks suffer weakness in their fundamentals, the market typically overreacts to it and values them extremely cheaply relative to their current earnings. A systematic quantitative value factor investing strategy therefore buys those stocks at their cheapest point and holds them until the market becomes less pessimistic about their prospects and re-values their earnings.
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