In this series of videos for Sparrows Capital we’ve looked at four different investment risk factors — in other words, four specific attributes that explain the return and risk of securities over the long term.
The fifth and final video provides an overview of factor investing, and in it we ask:
- How does it differ from quant investing and smart beta?
- How has factor investing evolved over the years?
- How strong is the case for adopting a factor investing strategy?
- And how do you go about implementing such a strategy?
If you missed the first three videos in this series, you can watch them here:
And if you’d like to watch more videos like this, why not subscribe to the Sparrows Capital YouTube channel?
Transcript:
Based on academic research dating back more than 40 years, factor investing has steadily grown in popularity. That growth accelerated after the global financial crisis, as prominent institutional investors embraced more systematic approaches to portfolio construction.
Factor investing is typically confused with quant investing and smart beta, but there are important differences.
In a nutshell, factor investing is a form of quant investing that seeks to exploit academically-proven factor premiums. It can be implemented within and across many different asset classes.
Factors refer to certain security-specific attributes that explain the return and risk of a group of securities over the long term.
An important concept to grasp is that factor investing is not designed to beat the market, but to deliver higher risk-adjusted returns.
In other words, the aim is to minimise risk and maximise return.
Depending on their needs and priorities, investors can either seek higher returns or reduce potential losses.
Research into the different factors that drive investment returns began in the 1970s.
In the early 1990s, Gene Fama and Ken French introduced their Three-Factor Model, which involved tilting portfolios towards value and small-cap stocks.
Since then, literally hundreds of factors have been identified. But only a small number of factors have been shown to be robust over time and across different markets.
In a landmark paper published in 2017, Elroy Dimson, Paul Marsh and Mike Staunton narrowed down the factors investors should focus on to size, value, income, momentum and volatility.
Factor investing does have its critics. There’s no guarantee, they rightly point out, that just because a particular factor has worked in the past, it’ll continue to deliver a premium in the future.
There are bound to be periods of underperformance, some of them protracted. Of all those factors we’ve just mentioned, only one, momentum, has outperformed over the last decade.
But the very long-term data in favour of factor investing are compelling. Multi-factor strategies have comfortably beaten the broader market. They’ve also had a higher Sharpe ratio.
But different multi-factor strategies can produce very different outcomes, so implementation is critical. And it’s not as straightforward as you might think.
For a start, you have to select which factors to use. You need to choose suitable indices, and the right funds or ETFs to track those indices. You also have to consider the weighting for each factor.
Simple in concept, factor investing is complex in execution.
How, then, does Sparrows Capital implement its factor strategies?
Essentially, implementation is based on six main principles:
— active risk is reduced by holding a combination of factors
— because factor timing is a fool’s errand, factor tilts are static
— using global single factor indices means investors benefit from increased market and currency diversification
— investments are made in separate vehicles, each targeting a specific factor, giving flexibility to control which factors to include and what weightings to apply
— weightings are based on standard deviation of single-factor excess returns, Sharpe ratios and correlations of factors, and
— when deciding the appropriate factor combination, the key criteria are risk and how factors correlate with each other.
In short, Sparrows Capital’s factor investing philosophy is strategic, risk-based, diversified and cost-efficient.
The evidence shows that alpha is elusive. Most fund managers simply don’t have the skill to generate value through stock picking or market timing. Those few managers who can add value tend to do so only over short periods, and usually absorb most of that value in fees.
But factor investing provides a far better alternative to traditional active management. By applying the findings of some of the brightest minds in academic finance over the last four decades, it is possible to produce higher risk-adjusted returns.
PREVIOUSLY ON TEBI
Institutional investors vs individuals: Who wins?
Indexing has saved Americans $357 billion since 1996
Specialised ETFs: high fees, poor performance
David Booth on 50 years of indexing
Why and how systematic strategies decay
Where are you looking for information?
Top-quartile returns guaranteed
CONTENT FOR ADVICE FIRMS
Through our partners at Regis Media, TEBI provides a wide range of high-quality content for financial advice and planning firms. The material is designed to help educate clients and to engage with prospects.
As well as exclusive content, we also offer pre-produced videos, eGuides and articles which explain how investing works and the valuable role that a good financial adviser can play.
If you would like to find out more, why not visit the Regis Media website and YouTube channel? If you have any specific enquiries, email Sam Willet, who will be happy to help you.
© The Evidence-Based Investor MMXXI
Robin is a journalist and campaigner for positive change in global investing. He runs Regis Media, a niche provider of content marketing for financial advice firms with an evidence-based investment philosophy. He also works as a consultant to other disruptive firms in the investing sector.
