Factor investing is an
investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Security characteristics that may be included in a factor-based approach include size,
low-volatility,
value
Value or values may refer to:
Ethics and social
* Value (ethics) wherein said concept may be construed as treating actions themselves as abstract objects, associating value to them
** Values (Western philosophy) expands the notion of value beyo ...
,
momentum
In Newtonian mechanics, momentum (more specifically linear momentum or translational momentum) is the product of the mass and velocity of an object. It is a vector quantity, possessing a magnitude and a direction. If is an object's mass an ...
, asset growth, profitability, leverage, term and cost of carry.
A factor-based investment strategy involves tilting investment portfolios towards and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation. Factor premiums are also documented in corporate bond markets and also across markets.
History
The earliest theory of factor investing originated with a research paper by Stephen A. Ross in 1976 on
arbitrage pricing theory
In finance, arbitrage pricing theory (APT) is a multi-factor model for asset pricing which relates various macro-economic (systematic) risk variables to the pricing of financial assets. Proposed by economist Stephen Ross in 1976, it is widely beli ...
, which argued that security returns are best explained by multiple factors. Prior to this, the
Capital Asset Pricing Model (CAPM), theorized by academics in the 1960s, held sway. CAPM held that there was one factor that was the driver of stock returns and that a stock's expected return is a function of its equity market risk or volatility, quantified as beta.
In the following decades, academic research has identified more factors that impact stock returns. For example, in 1981 a paper by Rolf Banz established a size premium in stocks: smaller company stocks outperform larger companies over long time periods, and had done so for at least the previous 40 years.
In 1993,
Eugene F. Fama
Eugene Francis "Gene" Fama (; born February 14, 1939) is an American economist, best known for his empirical work on portfolio theory, asset pricing, and the efficient-market hypothesis.
He is currently Robert R. McCormick Distinguished Servi ...
and Kenneth B. French published a seminal paper that demonstrated a value premium, or the fact that expected returns of value stocks were higher than for growth stocks.
The roots of
value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
date to decades earlier with the work of
Benjamin Graham
Benjamin Graham (; né Grossbaum; May 9, 1894 – September 21, 1976) was a British-born American economist, professor and investor. He is widely known as the "father of value investing", and wrote two of the founding texts in neoclassical inves ...
and
David Dodd
David LeFevre Dodd (August 23, 1895 – September 18, 1988) was an American educator, financial analyst, author, economist, and investor. In his student years, Dodd was a ' and colleague of Benjamin Graham at Columbia Business School.
The Wall ...
as outlined in their 1934 book ''
Security Analysis
Security analysis is the analysis of tradeable financial instruments called securities. It deals with finding the proper value of individual securities (i.e., stocks and bonds). These are usually classified into debt securities, equities, or som ...
'', and their student
Warren Buffett
Warren Edward Buffett ( ; born August 30, 1930) is an American business magnate, investor, and philanthropist. He is currently the chairman and CEO of Berkshire Hathaway. He is one of the most successful investors in the world and has a net w ...
outlined their findings and application in his 1984 article "
The Superinvestors of Graham-and-Doddsville
"The Superinvestors of Graham-and-Doddsville" is an article by Warren Buffett promoting value investing, published in the Fall, 1984 issue of ''Hermes'', Columbia Business School magazine. It was based on a speech given on May 17, 1984, at the Col ...
".
In 1993, Sheridan Titman and Narasimhan Jegadeesh showed that there was a premium for investing in high momentum stocks. Other significant factors that have been identified are measures of corporate profitability, asset growth, volatility, external financing, leverage and research and development costs.
The value factor
The earliest and most well-known factor is value, which can be defined primarily as change in the market valuation of earnings per share ("multiple expansion"), measured as the
PE ratio
Pe may refer to: Physical education
Language
* Pe language
* Pe (Cyrillic), a letter (П) in the Cyrillic alphabet
* Pe (Semitic letter), a letter (פ ,ف, etc.) in several Semitic alphabets
** Pe (Persian letter), a letter (پ) in the Arabic al ...
. The opportunity to capitalize on the value factor arises from the fact that when stocks suffer weakness in their fundamentals, the market typically overreacts to it and values them extremely cheaply relative to their current earnings. A systematic quantitative value factor investing strategy therefore buys those stocks at their cheapest point and holds them until the market becomes less pessimistic about their prospects and re-values their earnings.
See also
*
Carhart four-factor model
In portfolio management, the Carhart four-factor model is an extra factor addition in the Fama–French three-factor model, proposed by Mark Carhart. The Fama-French model, developed in the 1990, argued most stock market returns are explained ...
*
Fama–French three-factor model
*
Low-volatility investing Low-volatility investing is an investment style that buys stocks or securities with low volatility and avoids those with high volatility. This investment style exploits the low-volatility anomaly. According to financial theory risk and return shou ...
*
Momentum investing Momentum investing is a system of buying stocks or other securities that have had high returns over the past three to twelve months, and selling those that have had poor returns over the same period.
While momentum investing is well-established as ...
*
Value investing
Value investing is an investment paradigm that involves buying securities that appear underpriced by some form of fundamental analysis. The various forms of value investing derive from the investment philosophy first taught by Benjamin Graham ...
References
{{reflist
External links
Alternative Asset ManagementLondon's Voices.com Attracts $18 Million US Investment
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