All you need to know about Factor Based Investing

April 3, 2020

What is factor based investing?

Factor based investing uses company’s attributes to select stocks and construct portfolios. Historically, selecting stocks based on factors such as earnings and dividends has shown to generate higher returns. 

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Does factor based investing work?

Stock selection based on these factors or attributes help to filter out noisy short-term trends and ensure outperformance in the long run.

This has been substantiated by numerous studies both by academics and practitioners. Appendix 1 lists a selected number of studies.

Benjamin Graham – the first proponent of factor based investing

The conceptual idea behind factor based investing has long been recognised – Benjamin Graham has proposed value investing way back in 1930s. Value investing is one of many factors in factor based investing.

How common is algorithm driven factor based investing?

Algorithm driven factor based investing  has been widely adopted by institutions. Adoption started with hedge funds and banks’ proprietary trading groups, then by larger institutional investors such as sovereign wealth funds. Recently, algorithm driven factor based investing has become mainstream via Exchange Traded Funds. 

Crea8 is here to make this easily accessible to you.

If a USD 1 trillion fund can adopt factor based investing, why can’t you?

The Norwegian Government Pension Fund has USD 1 trillion assets. In 2009, it commissioned 3 professors from top universities to evaluate what they could have done better with their investments.

In the report, the professors recommended factor based investing:

Factor based investing’s performance drives its popularity

Factor based investing has proven to deliver higher returns and outperform. Consequently, Factor based investing has become more popular.

Crea8 has been able to bring Factor based investing to you because of:

  • Powerful algorithms: complex computation using big data is possible and at a fraction of time and cost.
  • Advanced technology: cheap computing power allows the collection and manipulation of large databases
  • Robust research: continuous R&D makes the process more streamlined and robust

Examples of factor strategies used by the practitioners

Factor Description
Growth stocks are generally associated with high-performing companies with an above-average net income growth rate and high P/Es.
Value stocks are undervalued, generally associated with companies that have stable net incomes or are experiencing a temporary cyclical downturn. Value stocks frequently have low price-to-book and price-to-earnings ratios as well as high dividend yields.
A tilt toward smaller size involves buying stocks with low float-adjusted market capitalisation.
Dividend Yield
High dividend-yielding stocks vs. peers outperform over longer term. This is more so in low interest rate environments.
Momentum attempts to capture further returns from stocks that have experienced an above-average increase in price during the prior period.
Quality stocks might include those with consistent earnings and dividend growth, high cash flow to earnings, and low debt-to-equity ratios.
Low Volatility
Low volatility is generally desired by investors seeking to lower their downside risk.

How are factor strategies applied?

Taking the value factor as an example, applying a factor based strategy would involve selecting companies with low price-to-book, and/or low price-to-earnings, and/or low price-to-cash ratios.

These companies might have experienced a bout of negative sentiment. Therefore, their stock price would dip, making it undervalued compared to historical prices or other similar companies. For example, Johnson and Johnson in 2018 which was involved in a lawsuit looked cheap based on the value metrics when its stock price slumped. 

When the sentiment improves, share prices would rise quicker than the market, giving portfolios with value tilts a leg-up over the market portfolio.

Avoiding factor based investing traps

We discourage a single dimension factor based investing – meaning we only form our portfolios using 1 metric.

Using the above value based investing as an example, if we were to select stocks using only say price-to-earnings ratio, we would only select those stocks with low price-to-earnings ratio. This has 2 problems:

  • Firstly, earnings are backward looking: The price-to-earnings ratio might be incorrect. This is somewhat mitigated by using future forecast earnings. However not all companies are covered by analysts to have earnings forecasts.
  • Secondly, it may be cheap for a reason: The company’s stock might be cheap for a reason. Hence, a single metric would not pick this up.

Factors over different economic cycles

Over time, the economy can go through many phases: Expansion, Deceleration, Recession and Recovery. Such cycles have been repeated throughout history.

Some factor strategies tend to outperform other factors depending on the economic cycle. 

By considering how different factors perform over the economic cycles, you can create a dynamic factor portfolio that can consistently outperform the market.

How Crea8 helps you in Factor based investing

On Crea8, investors can overlay professionally created themes with different factors. On Goal based investing, select ‘Factor based investing’ theme in Analytics and Advisory. On Factor based investing:
  • Under Advisory, we offer ‘Balanced’, ‘Value’, ‘Dividend’ and ‘Growth’ tilts to the strategies. So, you can easily switch between factor tilts. Furthermore, you can create your own combination using our Pro version. Our algorithm will ensure that the recommended portfolio is optimal.
  • Under Analytics, you can screen for stocks based on different characteristics. These include price-to-earnings ratio, analysts’ forecast and more.

Invest the same way as professionals but without the high fees

In the past, only professionals like fund managers had the tools and the ability to apply factor based investing strategies.

The differences between these funds / unit trusts and Crea8 are:

  • With funds/unit trusts, you employ fund managers to run factor based investing, paying them high fees;
  • With Crea8, you adopt Crea8’s algorithm driven factor based investing, but pay significantly lower fees.

Hence, Crea8 lets you invest in the same way but at a much lower cost. This is because Crea8 has distilled factor based investing into an easy to use tool. Furthermore, this tool is easily available and provided at a fraction of the fees charged by traditional fund managers.

Back test your strategies with ‘what ifs’ before investing

For any strategy that you create, you can backtest and evaluate the portfolio across various scenarios before committing real money.

Crea8’s Advice

With Factor based investing, you get to tilt your portfolio to maximise it’s value across different economic cycles.

Let Crea8 help you do this with our Factor based thematic investing service.

If you want to learn more

For further insight into our investment methodology including our Factor based investing methodology, check out our white papers.

Appendix 1

Ang, A., W. Goetzmann, and S. Schaefer, ‘Evaluation of active management of the Norwegian government pension fund-global. Report to the Norwegian Parliament’, 2009, https://www0.gsb.columbia.edu/faculty/aang/papers/report%20Norway.pdf

Chan, K., Chan, L. K., Jegadeesh, N. and Lakonishok, J., ‘Earnings quality and stock returns’, Journal of Business, Vol. 79, 2006, pp. 1041–82.

Chan, K. and Lakonishok, J., ‘Value and growth investing: review and update’, Financial Analysts Journal, Vol. 60, 2004, pp. 71–85.

Desai,H., Rajgopal,S. and Venkatachalam,M., ‘Value-glamour and accruals mispricing: one anomaly or two?’ Accounting Review, Vol. 79, 2004, pp. 355–86.

Dissanaike, G. and Lim, K-H, The Sophisticated and the Simple: the Profitability of Contrarian Strategies, European Financial Management, Vol. 16, No. 2, 2010, 229–255 doi: 10.1111/j.1468-036X.2008.00466.x

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