In this infographic from MSCI, we use scenarios from everyday life to explain how factor investing works.
What is Factor Investing?
Simply put, investors choose stocks based on the “factors”, or characteristics, that help explain investment performance. They are typically aiming for:
Higher returns Lower risk More diversification
While you may not have actively incorporated factor investing in your current portfolio, almost everyone will be familiar with the underlying concepts in real life. Here are five common factors and scenarios where you likely experience their principles.
1. Low Volatility Factor
The low volatility factor attempts to capture excess returns to stocks with lower than average risk. This factor has generally performed best during economic slowdowns or contractions. How you may experience it: If you want a writing career with relatively reliable income, you’ll likely choose to be a marketer at a large company rather than a self-employed author.
2. Quality Factor
The quality factor attempts to capture excess returns in shares of companies that are characterized by low debt, stable earnings growth, and other “quality” metrics. This factor has generally performed best during economic contractions. How you may experience it: When you’re purchasing new tires for your car, you might consider characteristics like tread longevity, traction, and fuel economy.
3. Value Factor
The value factor attempts to capture excess returns to stocks that have low prices relative to their fundamental value. This factor has generally performed best during economic recoveries. How you may experience it: If you want a good deal, you may look for items that are on sale.
4. Momentum Factor
The momentum factor attempts to capture excess returns to stocks with stronger past performance. It has generally performed best during economic expansions. How you may experience it: When you’re deciding what to watch, you may choose a TV show that has high audience ratings. You’ll likely also recommend it to your friends, which further boosts viewer numbers.
5. Low Size Factor
The low size factor attempts to capture excess returns of smaller firms (by market capitalization) relative to their larger counterparts. It has generally performed best during economic recoveries. How you may experience it: When you’re learning a new sport, you’ll see larger increases in your skill level than a professional athlete will.
Understanding Your Investments With Factor Investing
These simple concepts are at work in your everyday life and in your investments. Targeting these factors can help you meet your investing goals, including maximizing return potential and managing risk. From 2000 to 2020, here’s how the risk and return of the above factors compared to the benchmark MSCI World Index. Annualized risk and gross returns in USD from December 29 2000 to December 31 2020 for MSCI World Factor Indexes.
All five of the factors have had greater historical returns than the benchmark index, and some have also had lower risk. With factor investing, you can better understand what drives your portfolio’s performance. on Last year, stock and bond returns tumbled after the Federal Reserve hiked interest rates at the fastest speed in 40 years. It was the first time in decades that both asset classes posted negative annual investment returns in tandem. Over four decades, this has happened 2.4% of the time across any 12-month rolling period. To look at how various stock and bond asset allocations have performed over history—and their broader correlations—the above graphic charts their best, worst, and average returns, using data from Vanguard.
How Has Asset Allocation Impacted Returns?
Based on data between 1926 and 2019, the table below looks at the spectrum of market returns of different asset allocations:
We can see that a portfolio made entirely of stocks returned 10.3% on average, the highest across all asset allocations. Of course, this came with wider return variance, hitting an annual low of -43% and a high of 54%.
A traditional 60/40 portfolio—which has lost its luster in recent years as low interest rates have led to lower bond returns—saw an average historical return of 8.8%. As interest rates have climbed in recent years, this may widen its appeal once again as bond returns may rise.
Meanwhile, a 100% bond portfolio averaged 5.3% in annual returns over the period. Bonds typically serve as a hedge against portfolio losses thanks to their typically negative historical correlation to stocks.
A Closer Look at Historical Correlations
To understand how 2022 was an outlier in terms of asset correlations we can look at the graphic below:
The last time stocks and bonds moved together in a negative direction was in 1969. At the time, inflation was accelerating and the Fed was hiking interest rates to cool rising costs. In fact, historically, when inflation surges, stocks and bonds have often moved in similar directions. Underscoring this divergence is real interest rate volatility. When real interest rates are a driving force in the market, as we have seen in the last year, it hurts both stock and bond returns. This is because higher interest rates can reduce the future cash flows of these investments. Adding another layer is the level of risk appetite among investors. When the economic outlook is uncertain and interest rate volatility is high, investors are more likely to take risk off their portfolios and demand higher returns for taking on higher risk. This can push down equity and bond prices. On the other hand, if the economic outlook is positive, investors may be willing to take on more risk, in turn potentially boosting equity prices.
Current Investment Returns in Context
Today, financial markets are seeing sharp swings as the ripple effects of higher interest rates are sinking in. For investors, historical data provides insight on long-term asset allocation trends. Over the last century, cycles of high interest rates have come and gone. Both equity and bond investment returns have been resilient for investors who stay the course.
