What is an investment factor?
Photo: PublicCo. Source: Pixabay. CC0
Investment factors are a way to understand why stocks or bonds perform the way they do. Investments can be classified by the kinds of risks they take. Bond returns are driven by duration, credit, prepayments, the yield curve, and – for global portfolios – currency risk. Stock returns are affected by company size, industry, quality, and country. Real estate is impacted by location and the type of property. And everything is exposed to the economy, inflation, liquidity, capital structure, management, and valuation.
One analogy is photography. A photo contains all kinds of elements: color, balance, form. But it also can be a scene of activity and contemplation, or a seasonal image – fall, winter, spring. There are as many ways to look at a photo as there are ways to analyze an investment.
Factors allow us to slice and dice a portfolio. We can look for factor correlations just like asset class correlations. By diversifying our exposure to economic risk, or deflation risk, or liquidity, we can reduce risk while maintaining long-term returns. At least, that’s the way it’s supposed to work.
Source: CFA Institute
Factor-based portfolios look very different from traditional buy-and-hold stock and bond portfolios. Exposure to credit risk comes from buying corporate bonds and shorting treasuries; exposure to valuation is created by owning a value stock index and shorting a growth stock index. There are a host of strategies that go into a true factor-based portfolio. They don’t look at all like traditional asset classes, just as a combination of random colors won’t look at all like a picture of mountains in the rain.
This approach can look more like a collection of hedge-fund strategies than a classic investment. While factors are real and help us understand what we’re exposed to, factors are also buzz-words, designed by marketers to create a new fad for people to hop onto. If folks aren’t careful, they wind up paying big fees for normal market exposure.
Source: CFA Institute
Factors are a useful analytical tool, but they can be misused to make people feel inadequate and that they need to buy a new product. Remember: investment growth comes from economic growth. There’s no magic or mystery there. Factors just help us understand what risks we’re taking.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”