22 Aug 2024 5 min read

LGIM explains: What is factor investing?

By James Giblin

The premise of factor, or factor-based investing is relatively straightforward - by holding assets with specific characteristics, investors seek to achieve higher returns or lower levels of risk relative to a broad market portfolio.

Factor_explain.jpg

Whether they’ve done so knowingly or not, investors have long since dabbled in factor investing. Benjamin Graham and Warren Buffett are possibly the most famous ‘factor-style’ investors, with their early use of the ‘value’ style of investing.

From CAPM to smart beta

The birth of factor-based investing within academic papers can be traced back to the 1960s with the advent of the Capital Asset Pricing Model (CAPM). This model introduced the concept of market risk premium, which posits that equity markets are expected to offer positive returns to compensate investors for taking on additional risk. This was a paradigm shift from the previous belief that investment success was solely due to a manager’s skill, introducing ‘market beta’ into the lexicon of investing.

While numerous studies over the following decades developed the factor concept beyond beta, it was a seminal 1992 paper by Fama and French that popularised these concepts. They suggested that while market beta accounted for roughly two-thirds of returns, ‘size’ and ‘value’ premia could further explain the performance discrepancies in diversified portfolios. Consequently, rather than selecting individual stocks, investors could potentially target outperformance versus the broader market by systematically selecting stocks that exhibited specific characteristics. As a result, the factor investing industry was born.

The last 30 years have seen a surge in factor research, propelled by advancements in computing power and data quality. A study in 2014 by Levi and Welch scrutinising over 600 different factors, which was followed by John Cochrane’s speech at the University of Chicago, referring to the “zoo of factors,” underscored the burgeoning field of factor research alongside the potential for dubious factors to emerge within the field.

The good, the bad and the profitable

Today, the evolution of factor investing continues unabated, evidenced by the proliferation of smart beta products and active managers explicitly targeting factor styles. As portfolio managers, our role has evolved to include a critical analysis of these factors, discerning which are significant and which may be noise. We not only pay close attention to scrutinising the different factors, we also seek to rotate between them over time to target appropriate exposure for portfolios.

While past performance is not a reliable guide to the future, the data suggests that factor-based investing has proven to be successful over the long run. If we take a look at the historical performance of US equity returns, for instance, with data stretching back to 1963, we can illustrate the impact of factor investing.

An initial investment of £100 in the market in July 1963 could have appreciated to just over £44,000, reflecting the general market growth. The ‘size’ factor, which favours smaller companies with growth potential, could have nearly doubled this return, increasing the investment to £77,000. Even more remarkable was the ‘quality’ factor, which focuses on companies with robust fundamentals, which could have turned £100 into £127,000. The value factor, targeting undervalued stocks, could have been the most successful, potentially boosting the initial investment to just under £200,000*.

Factor_explains1.png

Short-term results appear far more mixed

While the above data illustrated the degree to which factor-based investing has historically delivered over extended periods, the short-term results have presented a more nuanced picture. Taking a closer look at the value factor, for instance, reveals that on a monthly basis, it has managed to outperform only 54% of the time[1].

This statistic, however, shifts favourably when the analysis is extended to an annual timeframe, with the historic outperformance rate climbing to 60%. Such variability underscores the inherent fluctuations within financial markets and the need for a strategic approach that can adapt to these changes.

A multi-factor approach can seek to balance short-term performance

The journey of the value and quality factors over the past 15 years serves as a testament to the importance of both a long-term horizon within factor investing, as well as the potential benefits of a multi-factor approach within portfolios.

During this period, the value factor experienced years of underperformance, detracting from its overall efficacy in five out of those 15 years. This trend, however, was counterbalanced by the robust performance of the quality factor, which emerged as a strong performer, outperforming in 10 out of the last 15 years. We believe this juxtaposition highlights the importance of a diversified investment approach[2] that does not rely on a singular factor.

The concept of correlation plays a pivotal role in the realm of factor-based investing, as the relationship between different factors can significantly influence the risk-return profile of an investment portfolio. For example, the value and quality factors have historically exhibited a weakly negative correlation according to the same data set shown in the earlier chart.

In conclusion, we believe that factor-based investing represents a sophisticated blend of historical insights and modern financial theory, offering a compelling framework for portfolio construction in today’s complex markets. We understand that active investing is hard, so must look to seize opportunities to gain an advantage when they arise.

 

[1] Source as per chart footnote

[2] It should be noted that diversification is no guarantee against a loss in a declining market.

 

James Giblin

Fund Manager

James is responsible for managing a range of retail multi-asset funds, including a number of client model portfolios as part of LGIM’s Model Portfolio Service (MPS). He joined LGIM from LGT Wealth Management where he was a portfolio manager on the Model Portfolio team. James is a member of the Manager Research Group (MRG), with a focus on alternative investments. James graduated from the University of Nottingham and holds a Bachelor of Science degree in Economics. James is a CAIA (Chartered Alternative Investment Analyst) charterholder as well as a CISI Chartered Wealth Manager.

James Giblin