Question

Discuss how factor investing may, or may not, be an improvement on the single factor (beta/CAPM) approach. Which of the factors seem most applicable, also, are there some factors that may not be appropriate in today’s market for some reason?

Answer 1

Factor investing is a strategy that chooses securities on attributes that are associated with higher returns.

There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.

Yes, it is an improvement on the single factor approach, as it consider multiple factors at a time.

Below mentioned factors seems most applicable in Factor Investing, :-

1. Value: Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.
2. Size: Earlier, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.
3. Momentum: Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame.
4. Quality: Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by using common financial metrics like return to equity, debt to equity and earnings variability.
5. Volatility: Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one- to three-year time frame is a common method of capturing beta.