Factor investing adds zing to your investment portfolio

The end game of an investment is to generate returns. The very notion of better returns itself is a comparison. A comparison to a benchmark, the broader market, peers, etc. it's the outperformance what everyone of us seek. Market returns could be achieved through either active or passive strategy. The former is where one continuously invests time and effort to pick the possible outperformers (alpha) of the future, the latter just employs being participated in the market to achieve market equivalent return (beta). Both are good strategies if one understands why they're employing either of it.

In health and career, there're certain important factors which determine the future growth of an individual. Nutrients like vitamins and minerals for health while academic and professional qualification for career paly a determining role. Similarly, investing in stocks is also determined by a set of factors which would influence the return possibilities. The field of identifying these factors and using it for the benefit of outperformance is factor investing. So, factor investing is based on academic evidence that strategies employing certain proven 'factors' provide outperformance over the market in the long run.

The origins of factor investing goes back to the '70s when empirical models began to question the assumptions of Capital Asset Pricing Model (CAPM) and Efficient Market Hypothesis (EMH), though the larger adaptation is attributed to a research paper published in 2009. The "Evaluation of Active Management of the Norwegian Government Pension Fund - Global Report" analyzed how the world's largest sovereign fund suffered losses due to the poor reflection of the active fund managers to their skills. The recommendations from the findings included an explicit top-down exposure to proven factors to maximize returns.

As more and more institutions began to embrace the passive investing strategies, factor investing slowly found its place in the overall scheme. Though, it's not a strategy designed to replace either of fundamental (active) or index based (passive) strategies, it's considered as third way of investing to achieve better diversification and enhance returns at lower costs. By early 1990s, the prospective Noble Prize winner Eugene Fama and his fellow researcher Kenneth French (F&F) have developed a three-factor model which became popular. It was basically an extension of CAPM, which assumed that a stock's average return was strongly related to its size (capitalization) and its valuation, not just to its market's exposure.

However, continuous improvements took place and by 1997, Mark Carhart proposed adding momentum to the mix. And on further iteration, F&F have added two more factors to their model i.e., profitability and investment, calling them as quality factors. Over the years, dozens of purported factors have been identified but instead of considering all, a few of the relevant ones are zeroed on. The requirements of any factor are performance, proof, persistence, explainable and executability. On this filtration, common equity factors derived are value, size, momentum, quality and low volatility. A few more like dividend yield and income.

There're no better or worse factors to be considered among these but investors should consider their goals in picking the factor(s). Each of them could achieve different outcomes and depending upon their priorities, investors could pick one or a combination of factors for their investment strategy. In recent years, however, products exploiting low-risk or low-volatility factors have been broadly accepted. The empirical evidence suggests that securities generating stable returns relative to the broader market have achieved higher risk-adjusted returns than riskier ones over the long term. Various reasons were put forth by academics to explain this anomaly, the most frequent relates to the rational behavior of the fund managers whose performance is usually evaluated against a benchmark. Therefore, they tend to focus on being able to deliver outperformance and on minimizing relative risk, thus tend to overlook low-risk stocks which are characterized with market-like returns and high tracking error.

(The author is a co-founder of "Wealocity", a wealth management firm and could be reached at [email protected])