An introduction to factor investing

It’s widely believed that a security’s risk is the most important driver of its price; in other words, that there is a direct and uncomplicated relationship between risk and return. However, numerous academic studies and long-term investment results reveal that there are many other drivers of long-term returns, commonly referred to as factors. Dissatisfaction with the relatively primitive approach taken by traditional passive investment strategies and concerns over the cost of investing in fully active investment strategies have led to the rise in popularity of factor investing.

Traditional ways to invest

Most of us are familiar with the concept of active investing, also known as stock picking. This method involves a highly skilled and sought-after portfolio manager at an investment firm having total control over the portfolio of investable assets. The portfolio manager invests in a list of securities in a particular universe that he or she thinks are undervalued and whose stock price will likely increase in the near future. The portfolio manager’s job is then to monitor and sell them for a profit. This investment method is lauded for its goal of beating the market, but common critiques are that it’s expensive, unable to beat the market consistently¹ and concentrated in a few stocks rather than diversified over many.

At the other end of the investing extreme is passive investing, also known as indexing, whereby an investment fund seeks to mimic the performance of an index by investing in stocks at the same weight as the index. This method was popularised in the 1970s² and gave investors who believed it was impossible to beat the market after fees diversified access to shares without needing their own broker. Many investors appreciate indexing’s simple and rules-based method of investing, whereas with active management, the methodology changes depending on the individual portfolio manager. However, to invest in an index fund, the investor or product must replicate the index, and this will naturally incur trading and management fees. So while the index might closely follow the performance of the market, an investor in an index fund can expect to underperform the market, net of fees. This is, by definition, how an index fund is constructed. Importantly, indexing is a strategy that relies on highly efficient markets. As more investors adopt this approach (and in some markets over half of the assets are passive), the markets become less efficient and the purpose of indexing is defeated.

So the two well-known investing options are:

1. Pay the higher amount required for possible, albeit difficult to achieve, outperformance.
2. Or, pay a lower cost for a broadly-diversified and unmanaged basket of stocks that will achieve market-like, but typically lower than market, returns.

Investors whose aim is to outperform the market, but also work within a budget, have therefore turned to factor investing. 

What is factor investing?

Factor investing is also a rules-based and transparent approach to building portfolios. Unlike indexing, factor investing aims to deliver excess returns, but at a lower cost than traditional active management. The key difference is that for factor investing, these rules are based on more fundamental measures of a company and its performance than on its market capitalisation alone.

Factor investing is commonly seen to be a mix of both active and passive management styles—investors look to it to extract the positive elements of active management (excess return) and mitigate the negative (higher fees). How is that possible and how did it come about? Research from noted academics³ throughout the 1980s and ’90s examined the determinants of stock returns. They concluded that if you analyse the performance of an average active manager, after adjusting for all factors and effects, the stock-specific return is almost negligible. Thus, most active manager returns are driven by individual factors working together. Factor selection - rather than stock selection - was the key determinant of outperformance according to the research. 

Figure 1 demonstrates that when you remove the factor returns from a portfolio’s outperformance, the return attributed to the stock selection itself is quite low. Removing factors such as value, momentum and stability shows that the majority of outperformance comes from the factor rather than the stock selection skills. This is consistent with research from our investment professionals that the outperformance of successful managers can be attributed to the presence of robust factor investing, allowing them to achieve outperformance with lower cost. Factor investing is particularly favourable when the pitfalls of passive investing are accentuated by volatile markets and overvaluations.

Having listened carefully to the needs of our clients, the launch of our Factor Allocation Global Equity Fund helps us to better meet clients’ needs by:

• Exploiting market inefficiencies
• Avoiding the deficiencies of passive investing
• Minimising investment fees
• Enhancing the value for members

SEI’s factor investing philosophy

Our strong belief in the benefits of factor investing led us to create an internally managed fund focused on the factors we believe outperform over the long term. SEI’s investment philosophy and history have always revolved around factor investing. Our proprietary research and experience, showing that factor investing can improve portfolio returns, dates back to the 1990s. The first step in our investment process is identifying the key drivers of risk and return in markets. The selected factor families are drawn from SEI’s alpha source framework, which is heavily researched and developed by both the factor portfolio management team and our manager research team. These factors are rooted in academic research, having been studied across varying time frames and geographies.

The primary factors our portfolio managers assess are:

Value

The ideal time to buy shares is when they are undervalued, found by market analysts comparing some measure of the company's market value to the fundamental wealth it generates. This is known as the value factor. This approach is only successful when share prices subsequently rise to generate a profit. If SEI's portfolio managers believe that markets are lower than they should be and due to rise, then they may invest a higher allocation to the value factor.

Stability

If our portfolio managers conversely believe that stock markets are overvalued and likely to fall soon, they turn to traditional, well-established and stable companies whose shares may not grow very dramatically, but that also tend not to suffer as badly when stock markets fall. This factor is known as stability, and when appropriate, the investment manager will invest a higher percentage of the fund in stable stocks. 

Momentum

Often certain industries or parts of the world become popular with investors. This means that almost regardless of how good a firm is, demand for shares in that industry or region pushes their share prices steadily higher. Relative returns over a recent time frame indicate strong returns going forward. That factor is known as momentum, and where markets favour those stocks, our portfolio managers will invest a higher percentage to momentum stocks. 

Next, we stress-test allocations of the factor families at a strategic level. SEI conducts factor-specific scenario analyses to measure performance across economic cycles, which helps inform the timing and sizing of our factor allocation decisions. 

Conclusion

Our recently launched Factor Allocation Global Equity Fund is focused on capturing the value, momentum and stability factors to generate outperformance. It answers a growing need of investors who are increasingly dissatisfied with the limitations of index funds. It is also backed by decades of investing and academic research.³ Those focused on responsible and sustainable investing should also note that this fund considers ESG as a factor alongside the equity factor model, as our research and experience indicates this ESG screen can help improve overall portfolio returns and lower risk.

To find out more about how factor investing can benefit your pension portfolio, please contact us.

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¹European active managers beaten by passives, 10-year study finds, Financial Times.
²Jack Bogle changed investing forever with index funds, but wasn’t always happy about it, CNBC, January 16, 2019.
³The Cross-Section of Expected Stock Returns, The Journal of Finance, June 1992.

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