While respecting this overarching principle, factor investing looks to optimise the risk/reward relationship in a portfolio by focusing on certain types of risk that academic studies suggest attract a persistent premium.
Delving deeper
At its heart, factor investing seeks to exploit the notion that biases exist in markets that naturally drive capital towards certain risk types and away from others. Associated movement and herding of capital present opportunities to investors who can identify such bias.
We can see this effect in the performance of so-called sin stocks, such as tobacco, which have continued to perform well in spite of the rise in responsible investing.
Imperial Brands, the tobacco firm, has outperformed the wider FTSE 100 index over one-year and five-year periods at the time of writing.
Neglected segments of the market must overpay to attract capital. For affected companies this means issuing shares at a lower valuation than the broad market.
For the objective investor, this translates into opportunity, since it means that future cash flows are effectively available at a discount. This can result in an above-market performance over time.
For example, studies by French and Fama, as well as Dimson, Marsh and Staunton, show that small-cap stocks have historically produced returns that outstrip the risks associated with them over the long-term.
Other identified factors include value, low volatility and momentum.
The value factor is an example of a historically out of favour sector that has produced a long-term premium.
Academic research on this factor takes account of so-called value traps – stocks whose share prices are indicative not of opportunity but of risk of failure, by eliminating survivorship bias from the data. Once this is done, investors still tend to see a marginally better risk/return.
The neglected market explanation is also used to explain the low volatility factor, because investors tend to favour more volatile stocks based on the expectation they will produce outsized returns if the broader market rises.
The resulting valuation difference, combined with the historical lack of success of such ‘super-star stocks’ (the magnificent seven are currently testing this concept) has historically meant that stocks with a lower volatility have tended to produce a better long-term risk/reward ration than the broad market.
The final factor that stands out is momentum. Here the academic justification is less about capital allocation by the market than about observable short-term migration of capital.
Evidence suggests that when the price of a stock starts to move up, investors notice and tend to herd into it, and that the resulting momentum will last for some time.
