What is factor investing?
Over the past 60 years, new findings in capital market research have increasingly changed our understanding of returns. While before 1960 portfolio performance was attributed solely to the skills of the respective portfolio manager, today a large part of returns can be traced back to factors. These factors can basically be described as statistically identifiable drivers of risk and return. Against this background, factors are nothing other than rule-based investment approaches that make active stock selection unnecessary. Perhaps the two most significant factors were proven in the early 1990s by Professors Eugene Fama and Kenneth French: Size and Value. The size factor invests exclusively in small companies, while the value factor targets undervalued companies based on their fundamentals.
What factors are there?
The most important thing: factors are not theoretical constructs, but are investable. Professional institutional investors have already been using factors very successfully for several decades.
For instance, 61%* of all institutional investors in Europe now use factor investing. Warren Buffett is considered the most significant value investor of all time.
What is the beta factor?
The beta factor is also called the capital market premium and refers to the excess return of equity investments compared to low-risk assets such as government bonds from countries that statistically have never or rarely defaulted.
In literature, this is understood to mean, in particular, the government bonds of Germany and some US states. Beta represents the compensation for the higher risks borne by shareholders.
What is the size factor?
The size factor refers to the effect where shares of smaller companies perform better in the long term than shares of large companies.
This is often understood as a risk premium for the fact that it is more difficult to obtain publicly sourced information for smaller companies.
This factor was discovered in 1992 by Nobel laureate Prof. Eugene Fama and Prof. Kenneth French.
What is the value factor?
The value factor describes the phenomenon where cheaply valued companies tend to show higher returns than more expensively valued companies.
How "cheap" or "expensive" a company is is assessed in terms of business metrics such as the price-earnings ratio (P/E ratio) or P/B ratio.
The value factor is often justified by the fact that value companies are more independent of hype cycles and thus perform better, particularly during recessions.
What is the momentum factor?
The momentum factor describes the tendency for shares that have risen in price to continue to rise in the near future, whereas those with falling prices tend to fall further.
The momentum factor is often explained by the fact that share prices do not price in new information completely and immediately, but rather this is processed over a certain period of time.
The momentum factor was proven by Carhart and, after the value and size factors, is considered one of the most significant factors.
What is the macro factor?
The macro factor refers to the effect where portfolios with a weighting by gross domestic product generate higher returns than those with a weighting by market capitalisation.
This is generally understood as a risk premium for the higher political risks in emerging markets.
What returns do factors exhibit?
Historically, factors have delivered higher returns than the overall market. However, factor investing works best over the long term. This is because individual factors can certainly underperform the market for several years in a row.
The best risk-adjusted results are achieved when factors are combined with traditional capital market investments in a portfolio. A portfolio consisting of the MSCI World and an equally weighted factor portfolio historically features a higher Sharpe ratio than the MSCI World alone.
Adopting the factor portfolio improves the annual return, while volatility remains almost the same.