Is Factor Investing the New Value Investing?

Ho Khinwai
Ho Khinwai

Here at Dr Wealth, we teach our flagship investment strategy known as “Factor Investing”.

But, if you haven’t been to one of our introductory classes, you might still be confused as to what this strange strategy is.

“Is it something that Dr Wealth created?”

“Is it a scam?”

“Is it some marketing bullsh*t that these investment trainers have come up with?”

Factor investing has been gaining popularity since the 2000s, after a few celebrity academics in Finance (Nobel prize-winners) published a study that claimed to beat stock market index returns and reduce risk – by investing in a portfolio of stocks selected through “factors”.

Image result for fama and french
Eugene Fama (left) and Kenneth French published the now-famous study “The Cross-Section of Expected Stock Returns” in 1992

The study also expanded how we understood Finance – since one of the founders had contributed to what is considered the foundations of Finance.

Soon, hedge funds and institutional investors started adopting this way of investing…

…and investors look in awe as funds like Renaissance Capital and Dimensional Fund Advisors (DFA) started making returns that would make Warren Buffett’s returns seem tiny (while apparently taking on lower risk).

The rise of Factor investing is still in its early innings – and we want to help you understand it before the masses learn about it.

It is akin to how value investing had started from an obscure strategy, and gained popularity when Buffett grew Berkshire to the monstrous return-generating vehicle it is right now. 

Don’t get me wrong – value investing still works. But, it is relatively much harder to find companies at huge discounts to intrinsic value (especially in the US) right now… if you’re simply using it as your main investing strategy.

The beauty of factor investing is – “value” is considered a “factor” style… so you’re never too far away from your familiar well-known strategies.

How Did Factor Investing Come About?

Academics have been trying to figure out how to maximize returns and reduce risk in the stock market for many years. 

Before factor investing (and even right now), Finance academics concluded that because of the Efficient Market Hypothesis and CAPM (don’t have to worry about what they are!), you simply need to buy the market index – because then you would be holding the best “risky asset” without taking on any additional unwanted risk.

The academics also unanimously agree that mixing this market index asset with “risk-free” bonds will result in the best portfolio you can have – that is the highest returns with the lowest risk.

This has been the way until other academics discovered discrepancies using the model in the 1970s – and started exploring why those discrepancies occurred.

No academic wants to be disproven – especially when they’ve won the Nobel Prize for the very work that is being disproved.

Eugene Fama, the father of the Efficient Market Hypothesis, started his own research – with another famed academic, Kenneth French – and published the now famous paper on factor investing that essentially salvaged his career and credibility in Finance academia.

The duo successfully justified how these discrepancies occurred – through expanding the paradigm of current Finance literature.

Fama and French alluded that these discrepancies (or ‘anomalies’ as some might call it) were not captured by the market’s risk, and the discovery of other “factors” – such as “value” and “momentum” could explain these discrepancies well.

And that, ladies and gentlemen (and everyone in between), is how factor investing shot to fame.

The Many Flavors of Factor Investing

Think of “factors” like lego blocks.

Each lego block has a different color – representing different themes or styles.

In Fama and French’s paper – they identified three lego blocks:

  • The “market beta” block
  • A new “size” block
  • A new “value” block

These blocks piece together to form a colorful stack, which is your overall portfolio.

Every investor would have a unique Lego stack – because each has different preferences and risk profiles!

This is why factor investing is commonly referred to as a portfolio construction method, rather than a method to do stock-picking.

Over the years, many other academics have been trying to get on the bandwagon and come up with various factors that seek to better explain discrepancies and use that to improve returns.

Mark Carhart significantly improved the explanatory power of returns by adding a “momentum” factor – in what is now known as the Carhart four-factor model.

Lu Zhang and friends, challenged Fama-French’s original factors and claimed that a new (but not quite new) set of factors – namely, the “market” factor, “size” factor, an “investment” factor, and a “profitability” factor – helps better explain most returns in the stock market.

Zhang and team thus called his model the Q-factor model, inspired by Tobin’s Q (q-factor), which is a number that tells an investor if a stock is undervalued or overvalued based on fundamentals and economic logic. This is reflected within their factors – as you can see, the investment factor and profitability factor are fundamental-based factors.

The Fama-French team, feeling a little uneasy, came up with a “new and improved” version of their factor model in 2014. The new model took the original 3 factors to 5 factors – and they look eerily similar to Zhang and team’s Q-factor model…

The New Fama-French 5 Factor (FF5F) Model includes:

  • The “market beta” block
  • The “size” block
  • The “value” block
  • A new “Profitability” block
  • A new “Investment” block

Further studies have been made that challenge certain existing factors and bring in new factors like “low volatility”, “betting against beta”, “cash conversion cycle”, “interest rates” or “liquidity”… but I won’t want to go into the details here.

By defining factors, investors can now custom-build portfolios based on the kinds of (risk) exposures they want. 

The only hitch is…

…it is tedious, difficult and expensive to manually build a factor portfolio by yourself.

The Downside to Factor Investing

As mentioned, factor investing works on the assumption that you build portfolios that are diversified between multiple different factors. 

This might mean that you need to allocate a huge sum of money to invest in a myriad of different factors. 

The outcome is that you could have too many stocks, with too complicated portfolio calculations, with huge fees eating out of your returns because you would need to trade and rebalance continuously every month or so.

Image result for tall lego tower
The taller it gets, the more effort you’d need to keep it standing!

One way investors can get around it is through investing in factor ETFs. 

These are low-cost ETFs that give you exposure to a particular factor – like Blackrock’s Value Factor ETF.

However, the downside of these is that these factor ETFs may pick up junk stocks too – and you have no control over how the stocks are being selected within the factor.

Moreover, factor investing is not 100% foolproof. 

Practitioners using factor investing have not seen as high returns as claimed by the research – although they still outperform the market.

Moreover, each factor has pockets of time where they go “out of favor” and don’t perform well. Investors need to understand this fact – and not run when your factor stocks go into negative return territory!

There are many more caveats in factor investing than what is written – and I’ll cover this in a whole ‘nother article soon!

Factor Investing Still Holds Water

Despite the downsides of factor investing, the thing is…

…factor investing works.

It is rigorously tested by practitioners and academics alike – and the one thing they agree on is that stock returns can be explained by distinct “factors”.

At Dr Wealth, we want to empower investors to use this tried-and-proven method to level-up their portfolios.

This is why Dr Wealth has been teaching our proprietary factor investing course – Intelligent Investor Immersive (I^3) for the past couple of years.

In this course, you won’t be subject to complicated math and statistics and whatnot.

In fact, I^3 is structured with the beginner in mind.

We touch on 2 key factors that have stood the test of time:

  1. Value (CNAV strategy)
  2. Profitability (GPAD strategy)

We guide you on how to use these factors – and eliminate “junk” stocks (like Hyflux) that are found within these factors.

This is also a lifelong mentorship programme where you don’t simply end with the “knowledge”.

We handhold you – and guide you step-by-step on how to buy your stocks and structure your portfolio in a way that matches the level of risk you are comfortable to take.

We give you the tools so you can screen your factor stocks easily with just a click of a button.

We open you to a community of like-minded investors – so that you can intelligently discuss stock ideas and get responses and analysis you know that are rational and based on sound numbers.

Lastly, we also check up on you and see how your portfolio and factors are doing.

I don’t think there’s a simpler and quicker way to invest than this.

If you are interested to learn how you can supercharge your stock returns while minimizing downside risk with factor investing, we have a free 2-hour intro-class where you can ask Dr Wealth himself (Alvin…) on ANY question you have about factor investing.

Click here to find out when’s the next one!

See you there!