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Is investing based on factors a hype or not?

  • Origin
  • Most important factors
  • Risks

In a previous article we already discussed passive investing and its risks. These insights have led to a new approach in the financial and economic world, namely factor investing: investing towards styles such as value, growth, smallcap, volatility, momentum… These factors are also called anomalies, because they cannot be explained by traditional investment methods. Meanwhile, worldwide almost 500 billion dollars is being invested this way.

 

Origin

Institutional investors are all confronted with the same problem. When you work with large amounts, you have to work with so many managers, up to the point where the focus has completely disappearerd.  Factor investment finds its origins in Norway. In 2009, the Norwegian State Oil Fund requested a number of scientists to make an analysis of fund’s return.

Their research revealed that their return could be optimised by taking certain factors into account. The factors considered the most valuable are momentum, value and low volatility. Since then factor investing in Scandinavia and the Netherlands developed towards an important alternative tendency in the investment world. According to Allianz Global, also in Belgium a growing interest is noted.

Rather than looking at geography and sector, factor investment involves looking at styles of investing that can be added to your portfolio. Mostly the scientific argumentation making a certain factor interesting to invest in, is considered.

What do these factors involve?

Most relevant factors

  • Momentum: shares recently performing well on the market, usually perform better than other shares in the subsequent period as well. One of the explanations for this behaviour is called “anchoring”, namely adhering to well-known values and thus buying the same shares repeatedly.
  • Value: here mainly shares with a low valuation regarding price/earnings ratio are selected. These shares are hence regarded as undervalued. The danger here is that shares having a low value due to problems, the so-called “distressed securities”, are bought.
  • Low volatility: this factor invests in companies with low volatility. Scientific research revealed that these companies get better returns than companies with high volatility. In 1972, this anomaly has been demonstrated by Robert Haugen, financial economist and pioneer in quantitative investing.

Research revealed that these factors explain 80 percent of the return out of a combined investment portfolio. However not all factors are interesting at the same moment. Nevertheless, it has been proven that investing based on one or more factors adds value.

Risks

Of course factor investment involves risks as well. Short- or medium-term, one or more factors can stay behind on the market. Looking at the factor value for example, there are periods where the return stays behind on the worldwide index.

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