5-Factor Investing: A Clever Way to Invest

Factor investing is an investment strategy that focuses on key performance drivers among asset classes. There are two types of factors to consider: macroeconomics and style. Macroeconomic indicators, such as economic growth, inflation, and interest rates, encompass broad risks across asset classes. In the 5-Factor Investing approach, value, quality, momentum, size, and minimum volatility are some of the style elements that can explain results within asset classes.

In this article, we will concentrate on the five factors that have been widely recognized by professionals: value, quality, momentum, size, and volatility.

Five Key Factors

The massive investment management titan BlackRock conducted research on them in order to create ETFs. They also identified these five factors – value, quality, momentum, size, and minimum volatility – that have shown to be resilient across time, markets, and asset classes and have a strong economic rationale:

1. Value: Value stocks are those that have low prices relative to fundamentals.
2. Quality: Quality investing strategies look for stocks that have higher quality earnings. That means that we are looking for profitable stocks, that have low leverage, and demonstrate consistent earnings over time.
3. Momentum: Momentum investing involves investing in stocks that have shown an upward trend in their price (in the case of long positions).
4. Size: Size investing involves investing in smaller companies with the expectation that they outperform larger ones.
5. Minimum Volatility: This factor seeks to build a portfolio of stocks that exhibits less variability than the broad market.

As the opening figure suggests, each of the factor categories is composed of a number of factors that branch out. In the field of investment, over 10,000 such factors are known. The Analytical Platform uses over 3,000 of them.

Let’s break it up and dig down more on the presented five (group of) factors.

This is a simplistic approach. In practice, factors can have exactly the opposite impact on price movements to that given in the examples above. This is the subject of our Newsletters and the Factor Investing software we develop.

Value

Value investing is based on the premise that certain companies are lower than their inherent value and will eventually revert to their fair price. Value stocks often have low prices in relation to their profits, dividends, book value, or other factors. Value investing is a type of contrarian investment since it includes purchasing stocks that are unpopular or out of favor.

According to BlackRock, value investing has historically delivered higher returns than the broad market over the long term, but it can also experience periods of underperformance. Value investing can be enhanced by combining it with other factors, such as quality and momentum, to avoid value traps (stocks that are cheap for a reason) and capture timely opportunities.

Quality

Quality investing relies on the idea that some stocks have higher quality earnings than others and will produce better long-term returns. Quality stocks exhibit high profitability, low leverage, and profit growth. Quality investment is a sort of defensive investing since it supports the purchase of stocks that are resilient and dependable.

According to BlackRock, quality investing has historically outperformed the broad market during periods of high volatility and economic downturns, but it can also lag during strong market rallies. Quality investing can be enhanced by combining it with other factors, such as value and momentum, to avoid overpaying for quality and capture cyclical opportunities. This trend can sometimes be seen in our strategies as well; our strategies overperform SP500 while having lower drawdowns than usual, yet sometimes, when there is a strong rally, our strategy falls under the SP500 performance.

Momentum

Momentum investing is based on the idea that some stocks have stronger price trends than others and that they will continue to outperform in the near term. Momentum stocks typically have high past returns over a certain period (usually 6 to 12 months) and tend to exhibit positive feedback loops (winners keep winning, and losers keep losing).

According to BlackRock, momentum investing has historically delivered higher returns than the broad market over the long term, but it can also experience periods of reversal and whipsaw. Momentum investing can be enhanced by combining it with other factors, such as value and quality, to avoid chasing bubbles and crashes.

Size

Size investing is based on the notion that certain equities have better risk-adjusted returns than others based on their market size. Size companies have small market capitalizations in comparison to the overall market or their rivals. Size investing is a type of diversification investing in that it includes purchasing stocks that are less connected with the overall market.

According to BlackRock, small-sized companies have historically delivered higher returns than the broad market over the long term, but they can also experience periods of underperformance, plus they are way riskier.

Minimum Volatility

Minimum volatility investing is based on the idea that some stocks have lower volatility than others and that they will provide a smoother ride for investors. Minimum volatility stocks typically have low beta (sensitivity to market movements), low standard deviation (variability of returns), and low correlation (relationship with other stocks). Minimum volatility investing can be seen as a form of risk management investing, as it involves buying stocks that are less exposed to market fluctuations.

According to BlackRock, minimum volatility investing historically tends to deliver higher risk-adjusted returns than the broad market over the long term, but it can also experience periods of underperformance. Minimum volatility investing can be enhanced by combining it with other factors, such as value and quality, to avoid performance drag and capture return potential.

To conclude, 5-Factor investing is a strong instrument that may assist investors in improving portfolio results, lowering volatility, and increasing diversity. Investors may make more educated decisions and perhaps earn greater investment returns if they understand the elements that determine outcomes.