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.

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‘Factor Based Investing’

An easy to understand infographic detailing the core differences between passive and active investment styles.

To be worthy of exposure, a factor 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 its premium and why it should continue to exist.
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.

  • 1. Market Beta – The stock market has a higher expected rate of return than risk-free assets. Typically, US short dated government bonds (Treasuries) are considered risk-free because they are backed by the U.S. government.
  • 2. Value – Stocks priced closer to their book value have higher expected returns than stocks priced far above their book value.
  • 3. Size – Small companies have higher expected returns than larger companies.
  • 4. Momentum – Stocks that have performed well tend to continue to perform well, at least for a short period of time.
    (Momentum Factor included in World and Earth portfolios only)

    * Fama, Eugene, and Kenneth French. 1993. “Common Risk Factors in the Returns on Stocks and Bonds.” Journal of Financial Economics, vol. 33, no. 1: 3–56 https://doi.org/10.1016/0304-405X(93)90023-5.
    ** Carhart, Mark. 1997. “On Persistence in Mutual Fund Performance.” Journal of Finance, vol. 52, no. 1: 57–82 https://doi.org/10.1111/j.1540-6261.1997.tb03808.x

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