Understanding factor investing: what's really driving your portfolio returns?

When we look at an investment portfolio, it is natural to focus on the individual companies it owns. However, knowing which stocks are in a portfolio only tells us part of the story. To understand what is really driving its returns, it can be more useful to look at the characteristics those investments have in common.

Investment

This is where factor investing comes in — and a simple analogy can help explain how it works: every meal we eat has a wide variety of ingredients, resulting in a huge diversity in terms of flavour, taste and our own enjoyment of the dish in front of us. However, when it comes to understanding the health effects of our diet, it is the balance of macronutrients in each meal – the mix of carbohydrates, proteins and fats – that matters more than the specific ingredients.

Building an investment portfolio isn’t the same thing as preparing a meal, of course. But the analogy is useful. Individual stocks (as well as bonds or other assets)make up the specific ingredients in our portfolio. However, these can share certain common characteristics, in a way not dissimilar to the macronutrients in our meal.

A portfolio might contain hundreds or even thousands of individual stocks, each with its own business model, industry and outlook. Yet if we look beneath the individual companies, patterns begin to emerge. Different stocks can share common characteristics that help to explain how they behave and what drives their returns. These characteristics are known in the investment literature as factors. These factors can both help us understand and explain what is driving our portfolio returns and be targeted directly when constructing an investment strategy. This discipline is known as factor investing.

Factor investing involves building a diversified portfolio focused on exposure to a set of factor characteristics, rather than taking a traditional approach to selecting stocks on the basis of fundamental security research. Examples of factors include momentum(stocks with positive price trends)or value (stocks with lower valuations when compared with peers or the broad market).

Putting factors into practice

When these factors are captured through a transparent, rules-based investment process rather than traditional active stock selection, the resulting approach is commonly referred to as smart beta.

Smart beta strategies sit somewhere between passive investing (“buying the market”) and active fund management (trying to “beat the market”). Rather than simply tracking the market or relying on a manager's views, skills or insight, it follows a published set of rules designed to target specific factor exposures in the investment portfolio, which are expected to add incremental benefits over the investment cycle.

One way to think about traditional passive investing is simply weighting stocks by their size (market capitalisation). This is the most common form of passive index investing. It automatically allocates more money to the largest companies, meaning those firms have the greatest influence on portfolio returns.

In contrast, a “smart beta” factor strategy takes a more deliberate approach by weighting companies according to specific factor characteristics, rather than simply their size.

One attraction of smart beta is that it removes much of the emotion from investment decisions, which can be a challenge for fund managers who actively select stocks. Rather than relying on a manager's judgement (i.e. active management), the same published rules are applied consistently across all companies, helping investors avoid many of the behavioural biases that can affect decision-making.

Our approach at atomos

As part of our investment style diversification, the atomos central investment proposition has allocations to smart beta strategies, among them the Global Equity Diversified Index (GEDI).“GEDI” was designed specifically to target three well-established factors: Value, Quality and Momentum.

What do these factors represent, and why does the strategy try and get exposure to them?

Value: Exposure to value means having more of your portfolio invested in companies with lower (i.e., cheaper) valuations compared with the market as a whole. Academic work has supported that these investments (on average and over the long term) can provide stronger returns than more expensive stocks. One rationale for this is behavioural: investors can become overly worried about short-term problems with a company (“recency bias”) and sell the stock, depressing valuations. The idea is that, over time, the market recognises the company's true worth and the share price recovers.
Quality: Focuses on exposure to well-run businesses that make healthy profits and have solid finances. These companies may not always grow the fastest, but they often deliver steady long-term returns because they are built on strong foundations. There is some evidence that the market “underappreciates” this characteristic over the long term, as investors often chase more “exciting” investment opportunities… until they fail to deliver on their expectations. It’s a classic story of the tortoise and the hare – just in the context of investment styles.
Momentum: Momentum investing (in its various forms) looks to invest in companies whose share prices have been rising over time. The idea is that successful businesses often continue to perform well as more investors recognise their improving prospects, which can help drive share prices higher– and that markets are slow to appreciate that.

It’s important to recognise that not all factor tilts or exposures will add value all the time, and that they go through periods of outperformance and underperformance like any other strategy. Consequently, a diversified and blended approach is desired to try and add value over the whole of the market cycle.

The chart below shows how different factors can take turns leading the market as economic conditions change (aka ‘the cycle’). Value often performs well during periods of recovery, Momentum can benefit when market trends gather pace, and Quality tends to provide resilience when growth slows or uncertainty increases.

While all three factors have delivered strong long-term returns, their performance can vary significantly over shorter periods. A factor that has been leading the market for several years can quickly fall out of favour, making it difficult to predict which style will outperform next.

Understanding factor investing: what's really driving your portfolio returns?

Understanding factor investing: what's really driving your portfolio returns?

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