Factor Based Investing

Factor based investing is an investment approach that involves targeting quantifiable characteristics, or ‘factors’, that can explain differences in stock returns.

Since the early 1960s, the academic community has been on a quest to uncover the ‘secret sauce’ of investing – the characteristics of stocks and other securities that both explain performance and provide premiums above market returns.

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‘Factor Based Investing’

An easy to understand infographic detailing the core principles of factor based investing.

A factor based investment strategy involves tilting portfolios towards and away from specific factors to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.

Factors are simply a set of properties common to a broad set of securities. Contrary to popular belief, it is the exposure to these factors, and not fund management skill, that determines performance.


For a Factor to be considered it must be:

  • PERSISTENT – it works across long periods of time and different economic regions.
  • PERVASIVE – it works across countries, regions, sectors and even asset classes.
  • ROBUST – it works for a variety of factor definitions and survives rigorous testing.
  • INVESTABLE – it works not just on paper, but also after considering implementation issues like trading costs.
  • INTUITIVE – there are logical risk-based or behavioural-based explanations for for its premium and why it should continue to exist.

Factors in EBI’s portfolios

More than 600 factors have been identified so far, but only a handful meet all of the criteria above. EBI’s evidence based investing approach identifies five key factors which it uses within its portfolios.

Minimum Volatility

Stocks which exhibit lower volatility have returns above that which would be implied by the efficient market theory.

Momentum

The tendency of stocks that have performed well, continuing to perform strongly into the future, at least for a short time.

Quality

Profitable firms generate higher returns than unprofitable firms, despite having significantly higher valuation ratios.


Value

Stocks priced closer to their book value, have higher expected returns than stocks priced far above their book value.

Size

Companies with a lower market capitalisation, exhibit a returns premium over companies with a large market capitalisation.

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