Factor Based Investing
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.
Factor based investing is an investment approach that involves targeting quantifiable characteristics, or ‘factors’, that can explain differences in stock returns.
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.
To be worthy of exposure, a factor must be:
Factors within EBI’s portfolios:
More than 600 factors have been identified so far, but only a handful meet all of the criteria above. For equities, the four factors that come closest to meeting these five criteria explain around 95% of the differences in returns between diversified portfolios. In 1992, Nobel Laureates Eugene Fama and Kenneth French first demonstrated a three factor model, where size and value factors are combined with the market beta factor to explain more than 90% of the differences in returns between diversified portfolios.* In 1997 Mark Carhart added a fourth factor, momentum, which further raised the explanatory power of the multifactor model.** So, if the market has returned 10% in a year and a diversified portfolio has returned 12%, the exposure to these four factors explains 95% of the 2% difference. Put another way, the degree of exposure to these four factors explains most of the return variation.