Factor Investing and Stock Selection

Factor investing has its origins in stock-based research carried out by Fama and French in 1992, which demonstrated the existence of a “size factor” and a “value factor”. Selecting stocks associated exhibiting these equity risk factors (small size and high value) appeared, over the long-term, to be associated with excess return. Since that time, other investing “styles” have been diagnosed which also seem to be associated with incremental investment performance. In particular, a “quality factor”, a “momentum factor” and a “low volatility” factor have become widely accepted in academic and practitioner work, and many asset managers have incorporated this approach into their stock selection process.

Unsurprisingly, not all researchers agree on the selection of the most effective equity risk factors. Our reference library enables investors very quickly to identify and assess the most popular research papers, and form a view on the efficacy of the various equity risk factors. As an introduction to the subject we would recommend a research report written by Savvy Investor and sponsored by Robeco, entitled, “Factor Investing: An academic source of Excess Returns”. This includes a discussion of which equity risk factors are used by each of the top asset managers in the Factor Investing marketplace.

For those investors wishing to consider factor-based portfolio analysis as an integral part of their stock selection process, you might wish to consider some of Savvy Investor’s research roundups. Looking at the two original Fama and French risk factors, you may wish to study some of the best papers on “Small Cap Investing and the Size Premium” or “The Value Factor and Value Investing”. For the more recently discovered factors, you could visit, “The Low Volatility Factor” or “The Momentum Factor: Using Momentum to generate alpha in stock selection”.

Not even the most ardent proponents of factor investing expect every factor to add value every year. For this reason, many investors prefer to take a “multifactor” approach to factor investing, whereby several factors are emphasised within the stock selection process. Where this approach is taken, it is important not to generate exposure to unintended factor risk, so a carefully constructed approach is required. Visit, “Analyzing Factor Exposures and Constructing Multifactor Portfolios” for the best recent papers examining a multifactor approach to stock selection.

If not every risk factor is going to add value every year, an obvious question is whether risk factor performance can be predicted. Can investors generate alpha through factor timing? Here the jury is still out. Some academics and practitioners advise measuring the “valuation” of each risk factor, and overweighting the undervalued factors, while underweighting the overvalued factors (most likely to reflect crowded trades). Others would argue that the best approach is a patient, long-term approach, keeping a steady allocation to the equity factors in which you have the most faith over the long-term. For a list of the best recent papers on this subject, see “Factor Timing, Factor Valuations and Smart Beta Forecasts”.

Although the practice of using factor investing within the stock selection process originated in the equity market, the fixed income market is not far behind. In recent years, many quant researchers have been focusing their attention on how best to apply factor investing in the corporate bond markets. Credit factors seem to work particularly well. Invesco, for instance, has developed a four factor credit model. To see the best papers in this space, visit “Applying Factor Investing to Fixed Income Portfolios”.

Each year, Savvy Investor analyses the best factor investing papers and gives awards to the best papers of the year, across a number of market sectors. For a lost of the best smart beta and factor investing papers, see “Best Factor Investing Papers 2018”.