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If you’re an investor in the stock markets, there is little chance you haven’t come across the Capital Pricing Asset Model or CAPM formula. In the quest to determine what drives stocks returns, this formula has come to be the foundation of stock valuations. The model proposes that the return on an investment is a function of its sensitivity (measured by the Beta) to market risk – thus, an investment with a high exposure to market risk (high beta) should earn higher returns. Thus, it essentially assumed that expected returns are determined by a ‘single factor’ framework. In general, a factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk. Based on this formula, the market can be viewed as the first and most critical equity factor. Works on this basic framework continued over the following years – the Fama and French model (1992), for one, proposed the 3 factor model providing evidence that the return variability of a stock can be explained by the exposure to size and value besides markets.
As an industry expert highlights, each asset class is made up of multiple factors driving risk and return. If asset classes are molecules, factors are the atoms serving as building blocks behind these molecules. This relation forms the basis of understanding the correlation between assets and thus helps in building a portfolio, going beyond what’s just above the surface and delving deeper. Factors are the underlying exposures that explain and influence an investment’s risk.
There are three main categories of factors today: macroeconomic, statistical, and fundamental. Arguably the mostly widely used factors today are fundamental factors. Fundamental factors capture stock characteristics such as industry, country, and valuation ratios amongst others. The most popular factors today are Value, Growth, Size and Momentum.
Why Factor Investing and what’s triggering interest in this field?
The period of the financial crisis of 2007-08 and its aftermath has seen an otherwise contradictory phenomena – asset prices for the broad asset classes, stocks and bonds, moved in the same direction. During the crisis, the value of these asset classes fell. During the recovery, their value rose. This has raised questions on the traditional diversification formula in constructing portfolios. It is this behavior which has triggered the intent of delving below the surface — Factor investing seeks to identify and mitigate risk factors with an aim to build a truly diversified portfolio.
Factor investing is here to stay – events over the last few years have provided fodder enough to keep the current institutional and retail investors around the world, increasingly attracted to these rules-based, transparent strategies that aim to capture alpha while offering an alternate way to the traditional diversification of portfolios. A recent survey by Blackrock (The Rise of Factor Investing, April 2016) provided the following findings:
• Factor use is widespread and on the rise: A majority believes that factor-based strategies can produce long-term outperformance relative to benchmarks, decrease overall portfolio risk and improve understanding of return-drivers.
• Investors who use factors are meeting their objectives: More than half have achieved greater diversification, and similar proportions have lowered risk and increased returns.
• Institutions are investing in a variety of factor-based strategies: More than half of the institutions surveyed use investment strategies targeting one or more factors, with value the most commonly targeted style factor and inflation the most commonly used macro factor.
• Looking ahead, institutions are taking steps to support further factor use: More than two thirds of those increasing factor use over the next three years will ensure they have appropriate risk management systems.
Did You know??
During the financial crisis of 2007-08, the value of broad asset classes, stocks and bonds fell. During the recovery, their value rose.
This raised questions on the traditional diversification formula in constructing portfolios.
It is this behavior which has triggered the intent of delving below the surface.