How can factor investing help you achieve your desired returns?

Welcome to Finance and Fury. In this episode we are going to look at the different factors to consider when deciding on how you should select investments

1. This is an interesting topic – as everyone will have different factors that influence their investment decisions – but the ultimate outcome for most people is to make money – i.e. you wish to receive a return on your initially invested capital – and do so at a rate that beats your opportunity cost – i.e. the next best use of the funds, like repaying debt
   1. But this is easier said than done though –
2. So in this episode – we will look at the major factors that influence investments and see which one has had the largest impact on out performing the index as well as minimising volatility – in other words, what has provided the best returns over the past 20 years at the lowest comparable level of risk – we will also look at if these trends can help to provide some insights into investing moving forward
3. I think it goes without say that this episode is not advice, but just general information based around a historical analysis – because we are not taking into account anyone’s personal situation

Why do investments perform the way they do?

1. This question has an obvious answer – the price of an asset is based upon the supply and demand of the investment – if the demand is high and the supply low or capped, then prices will rise – but it isn’t this simple – it is easy to say that an investment is simply in high demand with lower supply – hence the price goes up – but this becomes more complex when trying to figure out why this has been the case? Why have certain investments been in higher demand than others?
2. focusing on the different factors that investments can have attributed to them can help to understand this nuanced question – this is where factor investing comes into the picture
3. What is Factor investing? It is an investment approach that involves targeting quantifiable characteristics – these quantifiable characteristics are what are referred to as “factors”
   1. These can help to explain differences in investments and how they have performed – both in terms of returns as well as volatility, which is the measurement of risk
   2. Now – a factor is any characteristic that can explain the risk and return performance of an asset
   3. The approach to identify these is considered to be quantitative – hence it is based on observable data, such as an investments price in relation to its financial information, rather than on relying opinions or speculation
4. characteristics that may be included in a factor-based investing include two general categories – being that of macroeconomic factors as well as style factors –
5. Macroeconomic factors – these are the larger picture economic factors that tend to influence markets at large
   1. Economic growth – This includes an investments exposure to the business cycle
   2. Real interest rates and inflation – which focuses on the risks of interest rate movements and the exposure to changes in prices that a business faces from price increases
   3. Emerging markets – these can be beneficial however are exposed to political and sovereign risks, as well as currency risks
   4. Liquidity – exposure to illiquid assets
   5. Each of these factors is important at the macro level – but instead – we will look at the other factors based around investment style factors
6. Those of Style factors – These include the value, volatility, momentum, quality, and size of the investments
   1. Value – A share is considered to be of value if the current price is considered to be discounted relative to their fundamental value, also known as fair value –
      1. As an example – say a share is trading at $10 – but some analysts punch the numbers and determine that this company, based around its free cashflow and growth prospects should only be worth $8 – then this would not be a value purchase – however, if a share was valued at $15 and trading at $10, then this would be an obvious buy
      2. Therefore – value investments aim to capture excess returns through purchasing shares that have lower prices than their fundamental value
         1. There are many different methods used – but most commonly, value managers track price to book and price to earnings ratios, dividend growth forecasts, and the present value of free cash flows as part of their fundamental analysis

• The best way to think about value investing is when you see a special at the supermarket – if an item is on sale, for 30% reduce price, are you more or less likely to purchase the item?

1. So in essence – The value factor attempts to capture excess returns to shares that have low prices relative to their fundamental value. This factor has generally performed best during economic recoveries – when fundamentals matter more to investors

1. Minimum volatility – This is a focus on stable, lower risk shares – i.e. those that are consider safe harbours, such as blue chips and have stable business models and often provide a service with a moat around them – essential consumption with companies like WOW or COL would be an example
   1. There is some research that suggests that shares with low volatility earn greater risk-adjusted returns than highly volatile assets – so whilst the total returns may not be as high as some small cap companies, they can have less of a downside –
      1. e. – a share providing a 10% return with a 10% volatility has a better risk adjusted return than a company providing 15% return with a 22% volatility p.a.
      2. These numbers are also based around the averages – because a risk adjusted return does not equate to an absolute return – as previously mentioned, one share may provide a return of 5% p.a. at 5% volatility, whilst another provides returns of 10% p.a. at 15% volatility – which would you prefer?
         1. It does depend on your situation – but higher returns for more volatility can be acceptable
      3. This comes back to the measurement for volatility – which is often done in the form of a variance – which can be further reduced to a standard deviation
         1. This measures the potential price movement of an asset from its mean value over a certain time period – most of the time this is from a one- to three-year time frame
         2. But volatility measures upwards movements as well as downwards – so if a share hypothetically does go up in value a lot over 3 years, even if it doesn’t have any major downturns in this period it would still look volatile

• The low volatility factor attempts to capture excess returns to share with lower-than-average risk – however this factor has generally performed best during economic slowdowns or contractions – when the downside risks of volatility are their highest – because remember that volatility also measures the upside movements – so being in low volatility shares in a bull market can lead to underperformance when compared to the index

1. Momentum – These are shares with strong upwards price trends – i.e. Shares that have outperformed in the past tend to exhibit strong returns going forward as long as their trends continue – because of this – these momentum strategies are grounded in relative returns from three months to a one-year time frames
   1. The momentum factor attempts to capture excess returns to shares with stronger past performance – and it has generally performed best during economic expansions
   2. This form of investment factor does require a higher level of active management behind it – it requires to buy into momentum as it is commencing and to get out prior to momentum fully losing steam – which is easier said then done

• Momentum can work very well whist there is momentum behind the price movement –

1. To explain this further – take for example a movie review – if you are deciding on what to watch, you are more likely to choose a movie that has a high audience ratings as well as if friends or family are telling you that it is a good movie – if it is highly recommended and your friends tell you to watch it, then you will likely watch the movie, boosting the viewer numbers – This doesn’t mean you will like the movie – but the trend is set and due to social conformity, you don’t want to be the only one who hasn’t seen this movie – the same sort of factors work their way into the share market – investors don’t want to be the only ones that miss out on the returns – so more people demand the share and the prices continue to rise – however – like movies, once everyone has seen it, the hype behind the movie starts to wane, box office numbers go down and people move on to the next blockbuster

1. Quality – This is the representation of investing into financially healthy companies –
   1. quality shares are often defined due to the company having low debt, stable earnings, consistent asset growth, and strong corporate governance
   2. Investors can identify quality shares by using common financial metrics like a return to equity, or debt to equity and earnings variability as well as dividend growth – so there is a fair bit of fundamental analysis required

• The quality factor attempts to capture excess returns in shares of companies that are characterized by their quality metrics – therefore this factor has generally performed best during economic contractions – there is some overlap with quality and value investing – most managers who focus on value investing will look at quality companies and make investing decisions based around the price of the asset compare to the fair value – but for a pure quality investor, they will just buy the company if it is of high quality, even if the price has is above the fair value

1. Size – This is the purchase of smaller, higher growth companies – Historically, portfolios consisting of small-cap shares exhibit greater returns than portfolios with just large-cap shares
   1. This is why I have been a major fan of small to microcap companies when putting together a portfolio, especially for myself when it comes to getting higher capital growth over the long term –
   2. The low size factor attempts to capture excess returns of smaller firms (by market capitalization) relative to their larger counterparts. It has generally performed best during economic recoveries

• This strategy can have higher levels of risk however – but by investing in the lower end of market caps of the share market, it can help investors capture the size factor for additional capital growth over large caps

These are the style major factors – But what is the purpose of this considering these factors when investing –

1. From a theoretical standpoint – why would anyone try to focus on size over the quality investment factor? – why not just invest in the index? the purpose of doing so is for three major reasons – to enhance diversification, generate above-market returns and to lower risks when compared to the index – but most importantly – tailor the allocation towards which of these is most important to you = would you prefer lower risk or higher returns?
   1. When looking at Diversification – factor investing can offset potential risks to investing in shares through targeting shares that provide long term drivers of returns – such as quality or momentum, which often have different performance cycles
      1. when markets crash equities tend to move in lockstep with the broader market – where the price of these go down across the board – however in down turns, some securities don’t decline by as much
   2. You might also want to invest in shares at a lower volatility, or risk when compared to the index – Through focusing on a diversification between different types of shares, in different sectors – the risks of investing purely in one factor or sector of the market is reduced
      1. But On top of this – you can focus on certain factors of the market that have lower volatility – such as the low volatility share factors
   3. You might also want Higher levels of returns – This is where Certain factors can also provide additional capital growth above the index, but with higher levels of volatility
2. In short – investors can focus on certain factors that meet their returns profiles – In every investment there will be all three components present (diversification, risk and returns)
   1. But through investing in certain factors – you can help to tailor an allocation towards your investment goals – do you want less risk/volatility? Do you not care about risk and just want higher growth? Do you want growth whilst still managing risks?
3. What factors help to achieve these sorts of goals? To answer this, we need to look at what are the risks and returns of each have been from 2000 to 2020 – comparing the risk and return of each factor compared to the MSCI World Index
   7. Value – return of 7.9% p.a. with a risk of 17.9%
   8. Minimum volatility – return of 7.6% p.a. with a risk of 11.1%
   9. Momentum – return of 9.4% p.a. with a risk of 14.8%
   10. Quality – return of 8.7% p.a. with a risk of 13.9%
   11. Low size – return of 8.0% p.a. with a risk of 17.0%
4. Compared these to the MSCI world index – which had a return of 6.6% p.a. with a risk of 15.6%
5. This time period of investments had some major ups and downs – but over the past 20 years, all five of the factors have had greater historical returns than the benchmark index, and some have also had lower risk –
6. If you are going for the highest returns – momentum investing would have provided the higher level of annualised returns – out performing the index by 2.8% p.a.
   1. This makes sense from a perspective of following trends – but interestingly it has also had a lower risk, measured through volatility, when compared to the index
7. If you are going for the lowest level of risk – Not surprisingly – Minimum volatility has provided the lowest risk – but also had the lowest return – it did out perform the index by 1% over this time period, but was 4.4% lower in the measured level of risk
8. Quality has also had a decent return with a relatively low risk – I find this interesting as some of these factors can overlap – remember that value and quality investors look at similar metrics, but the major difference is the price that they have set to their entry points – hence, if a share has momentum behind it – a value manager will likely not purchase this, whilst a quality manager will

The downsides to this style of investing – trying to guess which factor to focus on and actively manager this yourself –

1. These attributes are readily available for most securities and are listed on popular share research websites – but it required the researchers to be correct and for you to constantly be checking to make sure the shares still meet the factor you wish to invest in
2. Trying to pull this off perfectly is impossible, trying to pull this off well is hard – but there are professional ETF managers who do this style of investments

So in summary –

1. If you are looking for high growth returns then small size, quality or momentum have historically provided above market returns over the longer term
2. However – if you are looking for lower risks in equities – both quality and minimal volatility shares can help to achieve this compared to the index – not to say that these investments don’t lose value, because they do in the short term, but historically they have had lower downside volatility when compared to the index
3. But through investing in certain factors – you can help to tailor an allocation towards your investment goals –
4. So depending on what your return requirements are, this style of investing can help to get investors closer to their returns profiles

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