November 7, 2019
3 min read
Fintech and Innovation
Nicholas Flaherty, Investment Strategist at FWU Invest S.A.
What are factors? And why use them?
Very simply, factors are a way to identify certain characteristics of stocks that enable them to outperform the market and thus make them attractive.
For example, one of the best-established factors is ‘value’, through which cheap stocks can be identified by assessing metrics such as Price/Earnings, Price/Book or Price/Cash Flow. As the data indicates, investing in companies that exhibit low values on these metrics will tend to outperform the market in the long run. Why this is so is still debated in the academic literature, but it appears that there is a deep behavioral bias within markets, whereby investors’ expectations of cheap companies become too negative, which then tends to correct only over time.
Another factor indicating excess performance is ‘quality’: companies with strong balance sheets and high cash flows. ‘Low volatility’ is also a factor – again the data shows us that stocks that are more stable, so fluctuate less in the market, will tend to outperform.
The idea with factors, then, is to identify characteristics of stocks that make them attractive, i.e. are proven to lead to outperformance. To be even more precise, we want to tilt our portfolio towards companies that score well on these metrics and move away from companies that do not. As noted, various factors have proven to lead to outperformance over the long term and that is good enough reason to include them in the process. But the problem is there can be a lot of variation in the short term. Indeed, in one year value may be the way to go, while in another year it may be quality. It thus makes sense to have a way to tilt factors in the direction of the most favourable.
We can achieve this by using ‘momentum’ analysis. Momentum is a way to identify rising trends and ‘jump on the bandwagon’. As decades of data show us, there is a tendency for stocks that have risen in the near past to continue rising in the future. Using momentum, then, we can identify areas of the market that are exhibiting a rising trend and we use this insight to pivot towards those factors that are gathering steam and away from those that are stagnating. For example, at the end of 2018 – a period which saw rising fear in the market based on the US-China trade war and global growth concerns – we saw, using our momentum approach, that the more defensive factors (such as ‘quality’) were moving up versus the market. We could capture this trend, allowing us to provide a better result than the market in general.
To sum up, we use factors to identify certain characteristic of stocks that have shown a tendency to outperform the market. But there can be a lot of variation in the short term and we use momentum analysis to capture this variation.