Exploring factor investing: An introduction
Authored by Anish Teli, Managing Partner at QED Capital PMS
“The king of Efficient Market Hypothesis (Nobel Laureate Eugene Fama) said that there were factors that had positive outperformance. It blew people away.”- Rob Arnott
What are Factors?
Different investing styles are called Factors, also called Style Premia, when they are defined by a single or a set of numerical characteristics common across a broad set of companies. For example, securities having cheap valuation, small size or high RoE companies, profitable companies, the ones having high returns over a period or less volatile securities, etc. Every factor has an economic or behavioural intuition or reason for why it works overtime.
The other way to think about Factor Investing is that it decomposes the driver of market returns and determines what drives those returns and tries to harness those characteristics to earn higher than market returns.
Factors that Work
Value Factor: Now, in the factor world, a value factor or style would be buying a portfolio of relatively cheap stocks and expecting it to outperform a portfolio of expensive stocks over a period. Value here would be defined here using a valuation metric like Price/Earning, Price/Book Value or Price/Fundamental accounting metric.
Momentum Factor: A much misunderstood and underappreciated factor is Momentum, which has a much longer empirical history than any other factor. Momentum is the tendency for assets that have performed well recently to continue to perform well in the future and vice versa. This phenomenon also plays itself out in markets as the effect of human behaviour or the tendency of investors to underreact to new information. This happens because it takes time for the investors to price new information.
Richard Dennis, aka Prince of the Pits, said, “At first I thought intelligence was reality and price the appearance, but after a while I saw that price was the reality and intelligence is the appearance.” In India, market old-timers have a saying: “Bhav Bhagwan Che” or price is supreme.
In an interview Professor Damodaran said, “You can create an investing strategy that’s momentum-free – but that basically means you value something and then you sit there and pray and hope that, eventually, momentum fixes the gap for you. Even those people who believe they’re value players are far more dependent on momentum than they realize, because ultimately, for them to make money, the price has to move to its value. And that may require a momentum shift, which is what we call the catalyst, something that changes the momentum of the game.”
Other well accepted factors are:
Low Volatility: Tendency of stocks with low volatility to deliver both higher absolute and risk-adjusted returns than most high volatility stocks.
Quality: The tendency of firms with high profitability measured by earnings and other similar metrics to have subsequent high returns after controlling for value factor as measured above.
Factor funds lie somewhere between discretionary active, and rule based passive funds. These are also called ‘smart beta’ funds. We like to think of them as “Active Beta” or Rules Based Active Funds.
It works over time, but not all the time
As simple as factor investing may sound, it is far from easy. They work over time but they don’t work all the time. And when they don’t work, it is very tough to keep going and follow your process. Like a batsman out of form. He will have to tweak his technique, but he can’t suddenly start batting left-handed if he is naturally a right-handed batsman. He will have to survive the rough patch. It is a mind game at that level. Most things are. Skill takes you up to a point. After that, it’s your temperament and psyche.
Buffett has seen many long stretches of underperformance. He has been written off many times, but every time he rises like phoenix from the ashes. Because, along with skill he has the temperament. If you cannot stand the heat, then get out of the kitchen, says Buffett’s long-time partner, the late Charlie Munger.
Disclaimer: Nothing in this article should be construed as investment advice. This is purely for educational purposes only. Please consult an investment advisor before investing.
Disclaimer: Nothing in this article should be construed as investment advice. This is purely for educational purposes only. Please consult an investment advisor before investing.