Global markets are made up of dozens of asset classes and millions of individual securities, making it challenging to understand what really matters for your portfolio. But, there are a few important drivers that can help explain returns across asset classes. These ‘factors’ are broad, persistent drivers of return that are critical to helping investors seek a range of goals from generating returns, reducing risk, to improving diversification.
Today, new technologies and expanding data sources are allowing investors to access factors with ease. In this article we will look at:
- What are factors?
- What is factor investing?
- History – The origins of factor investing
- Factor classification
- Macroeconomic factors and significance
- Style factors and significance
- A factor investor’s perspective : The economic cycle
- Steps involved in factor investing
- Why should you include factor investing in your portfolio?
What are factors?
According to Blackrock, “Factors are the foundation of investing, just as nutrients are the foundations of the food we eat.” We need carbohydrates and protein to power through the day, which we can find in different foods like bread, milk, and fruit. Putting together a balanced diet means understanding what nutrients are contained in our food, and choosing the mix that best supports our body’s needs.
Similarly, knowing the factors that drive returns in your portfolio can help you to choose the right mix of assets and strategies for your needs.
What is factor investing?
Historically, one of the most prevalent investment strategies has been:
Active Investment – Here, a fund manager along with his team of analysts strategizes and analyses individual stocks to beat the market. In Active Investment the skill of the investment manager enables a fund to perform better than the market. The operations of the fund involves hedging and a lot of buying and selling activity takes place.
Passive Investing – Here the portfolio tracks the market. In Passive Investing the investors are in for the long haul. The buying and selling that takes place are lower than those compared to Active investing. The expenses are significantly lower in comparison as Passive Investment uses programmed computers in place of fund managers.
Factor Investing – It comes into play by combining the Active Investment strategy and the Passive Investment Strategy. The Active Investment strategy can be used to acquire a portfolio apt with the factors and this can be programmed into a computer. The software will be able to replicate the strategy and at the same time analyze a range of stocks.
Factor Investing identifies characteristics of securities that can be targeted and structure portfolios to either capture or avoid specific factors in a systematic way.
Common Objectives of Factor Investing:
To use a rule based framework to position the portfolio in an attempt to outperform the market.
To contribute to portfolio diversification or as a risk control mechanism.
To use a cost efficient way to lower overall portfolio costs.
Investment factors have an intuitive approach and explanatory power, due to which, factor investing is becoming a strategic, long-term element of many asset allocations. Factor investing is currently receiving much attention, but the approach as such isn’t new — its roots can be traced as far back as the 1960s.
History – The origins of factor investing
The formal foundations for factor investing  were laid in the 1960s with the Capital Asset Pricing Model (CAPM) developed by William F. Sharpe, John Lintner and Jan Mossin. It made a distinction between alpha as a measure of excess return compared with a benchmark, and beta as market risk.
In the Fama- French three-factor model (1992), developed by Eugene Fama and Kenneth French, the size and value premium were combined with market risk for equities.
In 1997, Mark Carhart expanded the model to produce the four-factor model by adding the momentum factor.
However, studies on the size and value factors were first conducted in the early 1980’s. Security Analysis, the famous book by Graham and Dodd, first published in 1934, touches on many of the same concepts at the heart of factors such as value and quality.
Therefore, factor strategies have long been used in active fund management as well — just not under the “factor” label or in the systematic way used today.
- A detailed trail of factor investing –
- 1964 – CAPM – The separation of beta and alpha: Using Markowitz’s mean variance analysis, Sharpe, Lintner and Mossin develop the Capital Asset Pricing Model (CAPM)
- 1972 – Low Volatility – Haugen and Heinz find that low volatility stocks realize extra risk– adjusted returns
- 1973–76 – Pricing Theory & Merton’s CAPM – Robert Merton’s Intertemporal Capital Asset Pricing Model and Richard Roll’s arbitrage Pricing Theory establish a theoretical framework for factor investing
- 1981 – Size – Banz finds that small cap stocks outperform large caps.
- Basu shows that low PE stocks generate higher returns than high PE stocks
- 1981–85 – Market Rationality – Shiller, DeBondt and Thaler start gathering evidence against market rationality
- 1992 – Fama & French 3 Factor Model – Fama/French 3-factor model adds size and value to the market factor
- 1993 – Momentum – Jegadeesh and Titman analyze a momentum factor
- 1997 – Carhart finds that a factor model including momentum improves performance
- 2008 – Asset Growth & Profitability – Asset growth: Cooper, Gulan and Schill find that asset growth predicts future returns; Profitability: Novy-Marx shows that operating profitability predicts future returns.
- 2015 – Hou, Xue and Zhang’s q-model based on profitability and asset growth dominates long- established ones.
- Fama and French add operating profitability and asset growth to their model, giving rise to the factor model
Factor investing consists in selecting securities based on certain attributes. But what attributes are we referring to?
Factor investors focus on features of securities containing material information about their risk and return.
There are two major categories: Macro factors and Style factors.
- Macro factors: Macro factors help to explain returns across asset classes like equity or bond markets.
- Style factors: Style factors help explain returns within asset classes.
Equity market returns have, in many cases, leapt ahead of economic fundamentals, making future returns dependent on earnings growth. Adding to investors’ difficulties are drawdowns occurring during periods of stress, which can be particularly painful and persistent. To navigate these challenges, many investors diversify their portfolio across stocks and bonds.
However, even a well-diversified portfolio may still be exposed to tremendous risk given the historically high correlation between the performance of a traditional 60/40 balanced strategy and equity markets.
The problem is that a seemingly unrelated collection of assets can still be exposed to common sources of risk — like inflation, central bank policy moves or a slowing global economy. As a result, the diversification that investors need can often be very difficult to find.
Blackrock research  suggests that we can explain more than 90% of the returns across asset classes through six primary drivers of returns, or factors which are explained below.
The macro factors are well-known and intuitive.
Economic growth – The reward for taking on the risk of economic uncertainty.
Key fundamental question: What is the overall health of the global economy?
Economic rationale: Growth-sensitive assets rely on economic expansion to generate strong returns, and will suffer when the global economy is weak. Investors can be rewarded a long-run premium for taking on the risk of a potential economic decline.
Measured by: Surprise in GDP, i.e. the difference between expected and actual growth
Investment exposure: Equities (public and private), real estate and commodities
Real rates – The reward for taking on the risk of interest rate movements.
Key fundamental question: What is the current central bank policy?
Economic rationale: Rising interest rates decrease the present value of future cash flows, notably the market value of nominal bonds. Investors can be rewarded a long-run premium for taking on the risk that interest rates will rise. Rate-sensitive assets have tended to perform well when real rates are falling, and suffer when rates rise.
Measured by: Surprise in real interest rates
Investment exposure: Global inflation-linked bonds
Inflation – The reward for taking on the risk of changes in inflation.
Key fundamental question: What are inflation expectations?
Economic rationale: Inflation-sensitive assets are those that do not adjust in value when price levels rise. For example, a fixed coupon of 5% becomes less attractive if prices rise, while the coupon remains unchanged. When inflation expectations rise, inflation-sensitive assets decrease in value.
Measured by: Surprise in inflation levels
Investment exposure: Nominal bonds
Credit – The reward for taking on default risk
Key fundamental question: What are default expectations?
Economic rationale: Investors can earn a premium for lending to corporations (rather than governments), bearing the risk of issuer default. Credit premiums are also linked to the strength of the global economy and the cost of capital, but offer more downside and less upside than growth-sensitive assets.
Measured by: Surprise in default rates
Investment exposure: Corporate bonds, high-yield bonds
Emerging markets – The reward for taking on political and sovereign risks
Key fundamental question: What is the current geopolitical climate in emerging markets?
Economic rationale: Investors can earn a premium for bearing the additional risk associated with investing in less developed and unstable markets. This includes the risk of political turmoil, currency devaluations and seizure of foreign assets. Emerging market securities are inherently more volatile and can sell off suddenly when market sentiment changes, so identifying and appropriately sizing exposure to emerging markets is critical to managing risk.
Measured by: Spread between emerging and developed securities
Investment exposure: Emerging market equity, emerging market debt
Liquidity – The reward for holding illiquid assets
Key fundamental question: What is the global demand for liquidity?
Economic rationale: Investors holding less liquid securities accept the risk that they may not be able to immediately sell their investment in certain environments. By forgoing immediate access to capital, investors can be paid a premium for bearing that cash strain and delaying consumption.
Measured by: Spread between small- and large-cap equities, volatility levels
Investment exposure: Small-cap equities, selling volatility
Multiple factors can affect individual asset classes. The diagram below given by Blackrock gives a detailed view of which factors affect each asset class .
- Nominal bonds can earn a premium for bearing the risk of inflation and the risk of rising interest rates.
- Corporate bonds can earn a premium for bearing credit risk in addition to rate and inflation premiums.
- Equities are driven largely by exposure to economic growth, plus a modest premium for inflation and interest rate exposure.
Small-cap equities are generally less liquid and more expensive to trade, earning an additional liquidity premium.
In recent years, the combination of cheap computing power and greater market data availability for researchers in quantitative finance has led to a dramatic rise in the number of market anomalies reported in academic literature. Purported factors have become so numerous that a growing number of experts have warned about a so-called “zoo” of new factors. However, most of these reported factors tend to be related to one another. They frequently turn out to be simply different, maybe more exotic, ways to measure the same phenomenon. In fact, empirical research shows that it is possible to bring the number of anomalies included in the zoo down to a handful of relevant factors.Investors should therefore be selective and focus on a small number of well-established factors.
According to Blackrock, to qualify as relevant, a factor should –
- Show a strong premium over long periods of time and across different markets and asset classes.
- It should have survived rigorous falsification attempts, both in academia and in-house.
- There should also be an economic rationale with strong academic underpinnings for each factor.
- A relevant factor should be implementable in practice that is generate superior risk-adjusted returns in real life conditions – after trading costs.
Value – Tilting towards under-valued companies. The value factor identifies companies which are relatively cheap based on certain metrics.
Seeks to Capture: Excess returns to securities that have low prices relative to peers with high prices in the long run.
- Commonly Captured by:
- Price to book (P/B) ratio
- Price per Earnings (P/E) ratio
- Cash flow yield
Why it may work?
Investors have a tendency to fall in love with certain companies and overprice them. Investors require an unreasonably high incentive in order to hold vulnerable companies or unfashionable companies, so less attractive companies become too cheap.
Academic research has demonstrated the long-term persistence of a value premium, with one of the first serious seminal academic studies being Basu (1977). Later on, Eugene Fama and Kenneth French became famous partly for producing research showing the value premium endures over long timeframes. Nevertheless, value investing can (and has) underperform(ed) over shorter periods.
Recent underperformance of value investing explained by Andrew Ang of Blackrock:
Simple measures of value such as low price-to-book companies (used extensively by Fama and French, for example) have disproportionately underperformed. Why?
One reason may be that book value does not very well measure intangible capital. Businesses are spending less and less on tangible assets (i.e. factories and machinery), while spending more on intangible assets (i.e. customer databases or trademarks). It’s not bricks and mortar, the new gold is data!
Many traditional (asset heavy) value companies are cyclical in nature. As the economy has slowed, those traditional value companies have trailed the performance of their more nimble growth-oriented counterparts.
In our current cycle, we can see economic effects at work. We see a slowing economic growth. This late-stage environment is one where value has historically struggled. In the current environment, we also see investors’ biases in over-extrapolating future growth as expensive stocks have surprised on the upside with strong earnings, but cheap stocks have not.
Future of value investing
The uncertainty around the persistence of a value premium falls sharply over longer timeframes. Recent research goes one step further and suggests not only is the value premium predictably persistent, but that its predictability and the presence of a value premium is evident across asset classes.
Given its strong economic rationale and the persistence of the value premium over longer periods, the confidence in value investing for long term is strong.
The value factor is the underdog – it’s not flashy, typically is surrounded by low expectations, and often begins to mount a comeback just when you least expect it.
Facts and Fictions about value investing
- Fiction –
- Value investing is an idiosyncratic skill that can only be successfully implemented with a concentrated portfolio.
- Value is a passive strategy because it is rules-based and has low turnover.
- Value is “redundant.”
- Value’s efficacy is the result of a risk premium not a behavioural anomaly and is therefore in no danger of ebbing going forward.
- Fact –
- “Fundamental Indexing” is, and only is, systematic value investing.
- Profitability, or quality measures, can be used to improve value investing and still be consistent with a risk-based explanation for value.
- Value investing is applicable to more than just choosing what stocks to own or avoid.
- Value can be measured in many ways, and is best measured by a composite of variables.
- Value standalone is surprisingly weak among large cap stocks.
If you like to read about the evidence of the given facts and fictions, you can refer the bibliography 
Momentum – Selecting stocks with upward trends in their prices, typically based on returns over the last 12 months.
Seeks to Capture: Momentum demonstrates that over six-month and twelve-month periods, winning stocks continue to win, and losers generally continue to lose.
- Commonly Captured by:
- Relative returns (6-mth, 12-mth, usually with last 1-mth excluded)
- Earnings revisions
Why it may work?
Explained in the OSAM  paper, the Economist puts it, “The efficient-market hypothesis assumes that new developments are instantly assimilated into asset prices. However, investors may be slow to adjust their opinions to fresh information. If they view a company unfavourably, they may dismiss an improvement in quarterly profits as a blip, rather than a change in trend. So, momentum may simply represent the lag between beliefs and the new reality”
It is within this “lag between beliefs and the new reality” that factors like Momentum can generate alpha.
Momentum represents the moment in time when investors over-extrapolate strong earnings growth too far into the future, and ignore the possibility of mean reversion. Stocks with unusually high growth rates get stretched well past fair value. This ‘stretching’ generates an excess return that eventually gets reversed through mean reversion. There are, however, disciplined ways to capitalize on momentum before this occurs.
Momentum strategies are usually justified by the findings of behavioural finance, which focuses on known modes of behaviour, such as the herd mentality, or anchoring bias.
Momentum factor provides an investable strategy for arbitraging human nature – By understanding the investing public’s tendency to chase returns, over / under react to news, and engage in ‘herding behaviour’
In simpler terms, you can think of Momentum as a ‘justified boom’ that eventually turns into a speculative rally as enthusiastic investors push up the price of a stock by buying at higher and higher valuations.
A Case study proving the momentum factor :
The ‘Rubber Boom’ in early 20th century London offers a perfect case study of how strong stock returns originally justified by growing earnings can quickly morph into a speculative ‘boom’. Investors chased returns, herded into rubber companies’ shares, and ignored information that indicated a reversal was likely.
To read about it in detail, please refer the article below:
‘After the Boom’, The Economist (June 4, 1910)
- Myths about momentum investing –
- Momentum does not survive, or is seriously limited by, trading costs.
- Momentum is much stronger among small cap stocks than large caps.
- Momentum cannot be captured by long-only investors as “momentum can only be exploited on the short side”.
- Momentum returns are too “small and sporadic”.
- Momentum does not work for a taxable investor.
- Momentum is best used with screens rather than as a direct factor.
- One should be particularly worried about momentum’s returns disappearing
- Momentum is too volatile to rely on.
- Different measures of momentum can give different results over a given period!
- There is no theory behind momentum.
To find evidence to prove the myths wrong, please refer to the bibliography .
Size – Favouring companies with smaller stock market capitalisations.
Seeks to Capture: Excess returns of smaller firms (by market cap)
- Commonly Captured by:
- Market Capitalization (full or free float)
Why it may work? On the one hand, it is claimed that small companies have better growth prospects than large established companies. On the other hand, analysts focus less on these companies, which therefore tend to be overlooked.
It is also said that the shares of small companies are not as liquid as those of their larger counterparts, with investors preferring the shares of large companies.
In some markets, the consistency and magnitude of the size factor is tenuous, but it is often observed that other investment factors seem to work quite well across smaller companies, which increases its usefulness.
Volatility – Biasing a portfolio towards securities with historically lower price fluctuations, or low market beta.
Seeks to Capture: Excess risk-adjusted returns to securities with lower than average volatility or beta.
- Commonly Captured by:
- Standard deviation (1-yr, 2-yrs, 3-yrs)
- downside standard deviation
- standard deviation of idiosyncratic returns, beta
Why it may work? For portfolio managers tasked with outperforming an equity index, low beta stocks may be seen as “risky” stocks to hold in a rising market. For that reason, a higher risk premium may ironically be required, in order to hold them.
Low Volatility portfolios are well-known to exhibit biases towards sectors like Telecoms, Utilities, and Real Estate as these businesses are less cyclical and therefore trade less volatile than the market.
Low-volatility stocks were great for risk reduction over the last few decades, protecting capital during equity market downturns
Quality – Investing in companies with steady earnings, low leverage and solid balance sheets.
Seeks to Capture: Excess returns to stocks that are characterized by low debt, stable earnings growth, profitability and other “quality” metrics.
- Commonly Captured by:
- Return on equity
- Earnings stability
- Dividend growth stability
- Strength of balance sheet
- Financial leverage or for bonds short duration
- High credit quality or low volatility
Why it may work? – The quality factor is perhaps the most intuitive factor. High quality companies may be better at allocating capital and generating shareholder returns.
It may be that investors systematically under-price quality companies because they are perceived as dull and unexciting.
Robert Noxy-Marx demonstrated in 2012 that the shares of highly profitable companies achieve better risk-adjusted performance than less profitable companies.
Criteria that are used to define quality include cash flows and debt ratios, as well as the quality of the management and business model, along with the market environment, and, with fixed income, a high credit rating, low duration, and low historical volatility. However, it is problematic that some elements of quality often can’t be measured, such as the value of a brand or good reputation.
A factor investor’s perspective: The economic cycle
There’s lots of uncertainty in the market and fear has become the primary driver of market pricing. But while markets are roiling, factors have performed as we would expect during a sharp selloff entering a bear market.
Factors are cyclical. While in the long run style factors have demonstrated a significant premium over broad markets, we don’t expect every factor to have a positive return every month or every year. Over the short term, factor returns vary over time. Taking exposure to several factors in a strategic allocation – through a multi-factor strategy for example – may provide a more consistent return experience.
Here is a graphical representation of which factors over/under perform during a 10 year Economic Cycle from 1964-2015:
- Key findings
- The persistent outperformance of certain investment factors across the economic cycle argues against passive equity allocations.
- Investment factors are not rewarded linearly across the cycle.
- Factor spreads tend to expand in and around recessions, suggesting there is greater potential for disciplined active managers to deliver outperformance during those periods.
- To further read about how factors perform in an Economic cycle, please refer bibliography 
Steps involved in factor investing
Blackrock research  indicates that it’s possible to tilt to various factors to add incremental return to a multifactor portfolio by over- and underweighting select factors relative to others, while maintaining long-term exposure to all factors.
Here’s an example of how you could engage in factor investing:
- Consider five equity style factors: value, size, momentum, quality and minimum volatility. For each factor, take into account certain indicators (explained under each factor) to determine whether to tilt towards or away from the factor.
- Start by assessing macroeconomic conditions to determine if the factor could be helped or hindered by the current environment. (Refer to: A factor investor’s perspective of Economic Cycle). For example, during the expansion phase of the business cycle, when growth is accelerating, the momentum factor has tended to perform well.
- Next, review valuation to see whether the factor is expensive or cheap relative to its own history. Relative strength measures whether the factor has had strong recent performance. Another signal, dispersion measures how much opportunity a factor has to outperform in the current environment—or how similarly or dissimilarly the universe of stocks demonstrates factor characteristics. More dispersion creates more opportunities.
- Each of the four indicators is valuable on its own, but it is even more effective to combine these four insights into a composite indicator. This tells us whether to under-, over- or neutral-weight the factor relative to the other factors, while still maintaining diversified exposure to all the factors over time.
Why should you look at factor investing?
There are several reasons why factor investing has gained so much importance recently.
First, exciting advancements in the study of asset pricing, largely from academia, have shown the huge potential for factor-based strategies to play a major role in diversified portfolios.
Second, factor analysis frequently helps explain portfolio behaviour in ways that were previously not well understood; even for portfolios that do not utilize a factor approach. Factors help explain risk and return, allowing greater granularity, control and customization. This transition is supported by decades of empirical research and is likely a permanent advancement in how assets are managed.
In a portfolio with traditional market-weighted strategies, index-based factor strategies (frequently referred to as “smart beta” strategies) can offer a cost-efficient means of increasing return potential of the portfolio or used as a tool to balance overall factor exposures.
Investors with a portfolio consisting of market-weighted strategies may use active quantitative factor strategies to apply customized objectives like ESG to pursue excess return or achieve a more effective risk diversification.
Investors who have traditionally invested in fundamental active strategies may decide to add factor strategies to increase diversification, smooth allocations, directly target factor premiums or lower total investment costs.
Investors who already use index-based factor strategies might switch to active factor strategies to achieve more efficient implementation, allow for advancements in techniques or increase effective risk diversification.
 Foundational Concepts for Understanding Factor Investing, Invesco (June 30, 2019)
 Macroeconomic Factors: Important diversifiers, Factor perspectives, Black Rock website
 Value Investing: The long-term appeal of the underdog, Black Rock Insights on Factor Investing.
 Fact, Fiction, and Value Investing (Cliff Asness et al, 2015)
 The Factor Archives: Momentum, Jamie Catherwood, OSAM (December 2019)
 Fact, Fiction, and Momentum Investing (Cliff Asness et al, 2014)
 The Economic Cycle: A Factor Investor’s Perspective, Ehren Stanhope, OSAM (May 2016)
 Factor Investing- A time to tilt, Andrew Ang (Jun 23, 2017)