Factor investing lies at the heart of modern portfolio management, providing investors with a disciplined way to harvest key sources of returns across asset classes. Due to changing financial markets and available data, factor investing approaches are constantly adjusting to new factors. In this post, we examine where factor investing stands now and how it is evolving as new factors such as ESG come into play in the constantly changing market landscape.
The Evolution of Factor Investing
Factor investing or smart beta is based on the above concept that some properties, referred to as factor exposure can be used to explain variations in returns at a security level. Value, momentum, size, and quality have been extensively studied in the literature1 with broad investor adoption.
But investing is a moving target. Greater competition, changing market structures, and unprecedented access to data and computing services have paved the way for the evolution of such strategies leading to the discovery of new factors (Bellezza & Slonim 2011).
Evolving Traditional Factors
While book value was useful for more traditional economic eras, it has clearly lost its appeal—as the global economy gets increasingly populated by knowledge and service firms. Modern metrics of value are inclusive of intangible assets, and ways cash flows behave and can indeed be 3x as useful for valuation.
Momentum— In addition to price momentum, investors now look at earnings momentum and analyst revisions to bring a more comprehensive understanding of market trends.
Quality: This has broadened out to return on equity, profit stability, and balance sheet health which gives a better overall picture of the financial wizardry behind corporate earnings.
Low volatility: Strategies now consider not just historical volatility but also forward-looking measures and downside risk metrics.
Size: Once an important factor, the size effect is now often packaged with other factors — primarily to hedge against potential risks associated with smaller companies.
Emerging Factors and Trends
New factors are still researched and added as the world of factor investing evolves. Current emerging signs include the following areas:
1. Environmental, Social, and Governance (ESG) Factors
Investors have grown more concerned about taking ESG factors into account Studies have shown that good ESG scores in companies can indicate potential long-term outperformance. ESG factors can be incorporated into existing factor strategies or applied as stand-alone factors.
Environmental: Greenhouse Gas Emissions and Energy Use, Water Management
Labor practices, product safety, and social/community relations
Corporate governance: Diversity on boards, executive pay & shareholders rights
2. Alternative Data Factors
The proliferation of new alternative sources has driven the formation. New non-traditional-data factors /* These are ALL Terrible Names but have to start somewhere */
Commentary: Collected from social media, the news (where we source product leaks), and popular/institutional analyst opinion.ImageTransparentColor BR — When it comes to market perception, our sister brand evaluates more sources with a focus on social media sentiment and retail investor reviews.
Satellite Imagery: Analyzing retail foot traffic, agricultural yields, or industrial activity data from satellite imagery
Credit card data shows consumer spending — and that can reveal a lot about how much money companies are making
3. Machine Learning-Derived Factors
Furthermore, due to recent advancements in artificial intelligence and machine learning better understanding is possible regarding some of the more complex non-linear relationships that arise within financial data;
AI-Driven Factors: Factor identification using machine learning (ML) to find new factors or super-factors
Natural language processing: Parsing company filings, earnings calls, and other unstructured texts to surface predictive signals.
4. Behavioral Factors
Factor strategies are expanding to include insights from behavioral finance:
See what investors are viewing on Wall Streetish>>
Equity Analysts Behaviour — Analyzing Historical Patterns In Analyst Forecasts And Recommendations
More corporate insider activity: One of my favorite ways to get the lay of the land about how insiders view their company.
Implementing New Factors: Challenges and Considerations
While the advent of new factors brings an opportunity to get more novel risk premia in a shorter holding period, investors need to be cautious about using these newly identified styles:
Data source: A new factor may be driven by an alternative data source that has little history or limited coverage;
Overfitting—There is a risk of overfitting due to the sheer volume of observed data, where spurious relationships are detected (which do not hold out-of-sample).
Costs: Some newly influential factors may be more costly to implement due to higher data costs or turnover.
Special Note on Regulation: Privacy and/or regulatory hurdles may be obstacles to investment based on data point size, changes in frequency, or reporting lag between alternative sources.
Integration to existing strategies: Investors should pay careful attention to these new factors and how they interact with the current factors and their exposures.
The Future of Factor Investing
Factor investing is still in its early days, but as it matures a few other factors will play important roles:
Customization: Greater growth in personalized factor solutions that account for individual investor preferences and constraints.
Dynamic Factor Allocation: Advanced factor timing in response to the market environment and factors valuations.
Investing Across Asset Classes2019 — Prime Harvest Tax-Free Bond Fund LP
Enhanced Transparency and Explainability: Increasing focus on the key drivers that explain why factors are expected to deliver in a particular segment of markets, particularly newer more machine learning-derived complex factors.
Sustainability Integration: More systematically integrated ESG factors into factor strategies across asset classes.
Conclusion
Factor investing remains a powerful methodology for systematically harvesting premiums over time. The universe of factors, however, is growing beyond conventional metrics due to changes in markets and the availability of new data. ESG, alternative data, machine learning, and behavioral finance are also new alpha spaces.
But if investors are going to layer on new factors they need to be applied with the same rigor and attention that other well-established return offsets have warranted for years. At the same time, successful factor investing demands a disciplined, data-tested process but also needs to be flexible and willing to adjust. Investors can continue to seek out enduring sources of returns within a changing market landscape by remaining up-to-date on developing strategies and nimble about emerging catalysts.