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Looking for a market beating strategy? Factor investing could be the one for you

by , 14 July 2014

Factor investing involves buying different stocks that share certain characteristics, which improves their chances of beating the market.

These characteristics include value, size, momentum, low volatility and quality. Studies have shown this strategy does work over the long-term.

So does it actually work? Let's take a closer look…

What are the risks associated with factor investing?

Factor investing has an impressive track record, Cris Sholto Heaton in Money Week explains. The strategy lies somewhere between passive investing (tracking the performance of an index) and active management.

Instead of trying to pick these stocks individually, you could invest in an index that has a high number of shares with the above characteristics.

But will it pay off?

Some researchers claim the higher returns from applying factor investing is down to investors taking on more risk. Yes, that may be true for some of the characteristics.

Factor investing outperforms the market hands down

Have a look at the chart below. On the vertical axis, it shows the annual returns for five MSCI World factor indices. On the horizontal axis, it shows the risk (shown by volatility) of each strategy.

Chart showing performance of factor investing

Value, momentum and size all beat the standard MSCI World Index. But they did so with more risk.

With quality companies, the risk is much less. They tend to shrug off whatever happens in the economy.

So if there is a relationship between risk and return, you shouldn’t achieve such high returns for taking on low risk. But, as you can see, they did perform.

This may be hard to explain in a theoretical way, but it could be down to behaviour. For instance, investors see these quality companies as dull and boring, so these shares are undervalued.

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Why factor investing looks worthwhile

From what the chart shows, it appears that taking on additional risk is worth it with the reward of higher returns. And if this continues, factor investing certainly looks like a market beating strategy to follow.

There is a chance that the stocks attracting the factor investors could become overvalued as a result of buying pressure. If this happened, they could no longer beat the market.

So there you have it, why if you’re looking for a market beating strategy, factor investing could be the one for you.

Looking for a market beating strategy? Factor investing could be the one for you
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