You’ve probably heard of “factor” investing but might be unsure of what it is and how it works. In this article we’ll go through the basic principles of factor investing with reference to Invesco’s recent white paper, “The Five Principles of Australian Factor Investing.”
In a nutshell, factor investing is an investment strategy whereby an investor chooses securities based on a certain set of factors.
So… an investor should identify characteristics in a stock, that they believe will indicate the stock’s success in providing high returns.
For example – a “value” factor will select securities that are attractively priced relative to their fundamental value. A low price-to-book (price-to-net-tangible-assets) ratio will tend to outperform in the long run. There are two types of factors that have been associated with an asset’s returns – style and macroeconomic factors.
These factors are drivers of returns that impact the returns of assets across different asset classes. Style factors are factors that explain risks and returns within each asset class, whereas macroeconomic factors are factors that explain risks across multiple asset classes.
Factors and their persistence can be different across markets: Invesco’s white paper looks more closely at this, and puts forward the basics that every adviser should understand about factor investing in Australia.
1.Everyone’s a factor investor – Invesco has delved deeper into factor investing by using a language processor to analyse the investment policy commentaries of 7,000 funds in the eVestment database. It found that fund managers agree “that the main drivers of stocks in the medium to long term are Growth, Quality and Value… you can add Size and Volatility into the mix as well.”
2. Australian equities are a growth-driven market – Without question, growth has been the main driver of market returns in Australian equities. Invesco’s Exhibit 3 displays this dominance with Momentum or Growth having the highest returns. And it all boils down to Australia’s position on the global stage, which has defined the structure of our market.
3. Diversification is key – This is where Quality and Value come into play. Invesco says superior long-term performance “occurs due to Value and Quality being complementary to the Momentum factor.” Factor diversification is a critical component of driving strong long-term returns, because:
- “Value reduces the tendency of Momentum to select stocks with strong growth at any price,” says Invesco.
- A Quality focus ensures that you’re picking companies that have sustainable earnings with a solid balance sheet and management team.
- A Quality focus also makes sure “cheap-for-a-reason” Value companies aren’t bought.
4. Factor Investing and ESG are perfect partners – Invesco says, “Factor investing is perfectly suited to delivering dual objectives of generating above-benchmark returns whilst being mindful of environmental, social and governance (ESG) standards.” That way, two outcomes are integrated whilst maintaining factor exposures to deliver returns. The below chart shows Invesco’s IQS ESG Flower – each petal of the “flower” being an avenue of ESG integration as part of a holistic approach.
5. Big on returns, small on cost – “Continuing to deliver returns in line with expectations” is the number one focus of the investment process, according to Invesco. For example, the total return of the strategy being 2 per cent a year ahead of the benchmark.