What is Factor Investing?
Factor investing is an approach that selects stocks based on attributes associated with superior returns. This method differs from the traditional one based on market capitalization. Rather than focusing solely on company size, it looks at various characteristics or "factors" that have historically shown potential for high returns.
Although Factor Investing is most popular among equities, more and more factors (or systematic characteristics) are being discovered in other asset classes. This testifies to the versatility and expansive reach of this strategy.
Types of factors
Factors can be grouped into two main categories: macroeconomic factors and style factors.
- Macroeconomic factors: These factors capture risks across different asset classes. Examples: inflation rate, GDP growth, unemployment rate.
- Style factors: These aim to explain returns and risks within an asset class. Examples: growth vs. value, market capitalization, industrial sector.
Many factors have been identified over the years, including:
- Value: Captures the excess returns of low-cost stocks relative to their fundamental value.
- Size: Historically, small caps have generated higher returns than large caps.
- Momentum: Stocks that have performed well in the past tend to maintain that performance.
- Quality: Described by low debt, stable earnings, consistent asset growth and strong corporate governance.
- Volatility: Low-volatility stocks tend to generate better risk-adjusted returns than highly volatile assets.
A distinctive aspect of factors is their significant variation over time. This characteristic enables traders to predict certain premium factors, opening the door to timing strategies based on factor timing.
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Factor investing and algo trading
The marriage between Factor Investing and algo trading is a natural one. Quantitative methods based on observable data, such as stock prices and financial statement information, enable algorithmic traders to create accurate models to exploit these factors. This approach eliminates human bias, relying instead on data-driven analysis.
Factor Investing has established itself as a must-have strategy for quantitative traders. With the right mix of factors and judicious implementation through algo trading, investors can successfully navigate today's complex financial markets. While the past cannot guarantee future performance, a thorough understanding of factors and rigorous application of research can offer significant opportunities for returns.
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