What Is Issue Investing and Is It the Proper Technique for You?
Regardless of your experience in the stock market, the overriding goal is the same: make as much money as possible. Who doesn’t want excess returns?
Everyone seems to have their own method of generating market-leading profits. As you read this article, you may find that certain topics come up, such as: B. tracking volatility and momentum, paying attention to company size and finding undervalued stocks.
As surprising as it may seem, the vast majority of long-term investing strategies that have the potential to beat market benchmarks fall into the factor investing strategies category.
What is factor investing?
Factor investing is a comprehensive strategy for generating higher returns while increasing diversification and risk management. Investors who practice factor investing aim to increase profitability by focusing their asset allocation on risk factors when making stock market decisions.
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One of the world’s most celebrated investors, Warren Buffett, is known for focusing on one of the most popular factors in the market: value. The billionaire investor is constantly looking for opportunities to pounce on undervalued stocks to try and make a coin while the market levels out and the stock’s price moves towards a fair market valuation.
Overall, factor investing involves investing in stocks that pay a premium for a minimally increased level of risk. Value is just one of many such factors.
Finally, value stocks that are undervalued often bounce back, but there’s also a chance a stock may be priced lower because of a systemic problem or corporate margins that continue to weigh on it. By taking this risk with many investments over time, Buffett’s and other value investors’ portfolios consistently beat the market over the long run.
There are two different types of factors to look out for, including style and macroeconomic factors. Here’s what to look for.
Common types of style factors
Investing in risk premia factors gives you the option to focus on a single factor or a mix of factors as a criterium for your investment activity.
Each risk premia factor offers both the potential to generate superior returns and a slightly elevated level of risk. Nonetheless, these factors have become popular because historically the benefits have outweighed the risks.
Risk premia factors known to be the biggest drivers of returns include:
Like Warren Buffett, value investors look to a wide range of valuation metrics to find stocks that are trading at a discount in hopes of reaping the rewards of the upside.
The value factor requires close attention to a company’s fundamental financials, including free cash flow, dividends, and metrics like price-to-earnings (P/E) and price-to-sales (P/E) ratios. .
The biggest risk associated with investing in value stocks is that there may be some reason for the undervaluation that the market is pricing in. For example, a recent FDA rejection could send a biotech stock into the abyss, resulting in low valuation metrics, and the risk of investing in the company would likely outweigh the benefits of the undervaluation.
The momentum factor is exciting because it focuses on stocks that are already moving in the right direction with significant momentum. Newton’s first law of motion states that a body stays in motion, and this is often true of the stock market.
A stock that enjoys high momentum and liquidity while outperforming average market returns could continue to do so for some time. Momentum investors look for technical clues to big uplegs so they can jump in at the start of a buying wave.
On the other hand, chasing momentum can be a relatively dangerous play. Momentum stocks are often overvalued, and a sudden correction can be lurking around the corner. As you focus on the momentum factors, pay close attention to the technicals and be ready to exit when the time comes.
The volatility factor indicates stocks with low volatility. That’s because historically, lower-volatility stocks have generally produced higher risk-adjusted returns than high-volatility stocks.
On the other hand, low volatility stocks don’t tend to produce stunning short-term gains. So this is a factor that suits long-term investors better than short-term investors.
Quality Score is measured using a variety of metrics, with the most common being a company’s debt-to-equity ratio, equity-to-equity ratio, and earnings variability.
Regardless of what metrics you use as a measure, the idea is to invest in high-quality companies with stable earnings, consistent growth, strong management, and low levels of debt.
Quality factors, including those above, should always be considered when making investment decisions. Finally, companies with stable earnings, consistent growth, strong management and low debt should outperform lower-quality stocks.
When using factor investing, you should consider the quality of the stock before taking the risk. For example, if you’re into value investing, you should look for stocks that are trading at below-average valuations that indicate strong quality signals.
Finally, the size of a company is another widely accepted risk premium factor.
Investors who pay attention to the size of the companies they invest in to boost returns tend to focus on small-cap stocks, which have historically outperformed their large-cap counterparts.
However, there is an art to investing in small-cap stocks. These companies aren’t as well established as large-cap companies, and as such often come with some additional risk.
Example: The Fama-French 3-factor model
The Fama-French three-factor model is one of the most commonly used factor investing models. It acts as an extension of the widely used Capital Asset Pricing Model (CAPM), which measures the relationship between risk and expected return for an asset. The Fama-French three-factor model was developed by Eugene Fama and Kenneth French.
The Fama-French three factor model focuses on three style factors:
- size. The model favors small-cap stocks over large-cap stocks.
- worth. The model relies on the book-to-market value metric to determine if the stock is undervalued.
- momentum. The model examines the excess return the stock has generated relative to the broader market.
The investment style suggests investing in smaller companies with strong value metrics that have relatively strong historical performance relative to the broader market and will generate superior returns.
Factor Investing with Mutual Funds & Exchange Traded Funds (ETFs)
If you’re not interested in compiling your own stock list, investment-grade funds like exchange-traded funds (ETFs) and mutual funds offer an inexpensive way to take advantage of the factor investing strategy.
Several ETFs are built around risk premium factors. The Vanguard Small-Cap Value ETF (VBR), for example, focuses its investments on two style factors — size and value — and has a long history of outperforming the broader market.
If you don’t have the time or ability to build your own investment portfolio, you should look for investment-grade funds with investment management styles that focus on risk premia factors.
Benefits of Factor Investing
There are several reasons to dive into factor investing strategies. Some of the most exciting benefits of these strategies include:
Who doesn’t want to make more money in the market? After all, making money is the name of the game. Factor investing was designed to make this possible. By relying on factors that are likely to produce higher returns, this investment style offers investors a simple yet effective way to beat the market.
No emotions allowed
When using factor investing, investments are made based on the risk premium factors you want to focus on. Following this type of strategy leaves no room for emotions like fear and greed to take hold and destroy your returns.
Disadvantages of Factor Investing
While there are many reasons to consider a factor investing strategy, there is also a significant downside that should be considered before getting started.
Factor investing is all about adding minimal risk with the potential to generate significantly higher returns. While the potential for profit generally outweighs the increased risk involved, it’s important to be clear in your research and understand all the risks that may be involved before jumping into an investment.
Is Factor Investing Right For You?
The truth is that when managed properly, an investment portfolio that focuses on risk premia factors is a good choice for almost anyone. After all, who doesn’t want to outperform the average market returns over the long term?
However, there is one class of investors for whom this investment style is not appropriate. If you are nearing or retired and extremely risk intolerant, the increased risk you must accept to participate in these strategies will likely be a deterrent.
If you already have a nest egg that you are actively drawing on, you may not be able to afford to take on additional risks in the here and now for a higher potential payout in the long run.
Factor investing offers an exciting opportunity to follow in the footsteps of countless investors who are consistently outperforming widely recognized benchmarks. However, it’s important to remember that increased potential income simply doesn’t exist without increased risk.
While research is important regardless of your investment style, the need for research becomes more acute as you take on additional risk. If you’re interested in adding a risk premium or two to your portfolio, make sure you’re willing to do the necessary research to do so successfully.