This is the first of a series of posts on factor investing.
In this first post, we shall introduce factors in equity investing. What are factors? How are they useful?
Early research on equity returns broadly took the position that most equity returns were market related, and it was not possible, in a broad sense, to improve upon market returns, unless you were prepared to take on additional risk. This idea, that has since led to the development of index funds, is the principal reason for the current popularity for ‘passive’ investing. The basic notion is that it is very difficult for ‘active’ managers to beat benchmark returns (especially, net of management fees), and therefore you were better off just investing in index funds.
The early research was since modified to include certain ‘factors’ which led to outsize returns over the market. These additional returns are often called ‘risk premia’, since the idea is that factors contribute to additional risk, and therefore people who are exposed to these factors need additional return to compensate them for the additional risk they are taking on. Some explanations of why factors give additional returns are behavioural, in the sense that there are some recurrent behaviour patterns amongst market participants, which lead to these apparent anomalies in stock returns.
So, let us differentiate between the ‘market factor’ and other factors. These other factors lead to differences in stock returns beyond what different levels of exposure to the market can explain. These other factors can be intrinsic to the particular stock (such as its earnings, or growth, or price movement etc.) or they can be extrinsic (Industry Growth, Interest Rates and so on). Empirical research, sometimes data mining in the guise of research, has thrown up almost 300 factors that impact stock returns. But not all these factors have a sound economic rationale or a well-established risk or behaviour-based explanation for why they give additional returns.
In the next post, we will examine which factors have been found to be useful over time, and which we can use for improving investment performance.