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Nov 05

How to work out what to invest in, using the ‘Factor Investing’ strategy

Reading Time: 7 mins

Have you heard of factor investing, or systematic investing, where you use a predefined rule which works out the best products for you to invest in?

It’s becoming more popular as a method of picking ‘winners’ on the stock market as you just ‘follow the science’ – or at least the numbers.

Using factors to decide what is going to be a good investment can often be a more sure-fire way of finding the right investments than, say, listening to the opinions of experts.

But where to you get reliable data from and how do you use it? Read on to find out.

 

what information do i need to invest wisely?

More and more of us are finding ourselves becoming investors. We may be building a pension pot for retirement, an ISA for tax-free treats down the line, or a Junior ISA university pot for a child or grandchild. Whatever it’s for, though, the fact is that investment can be a pretty daunting process, with significant sums of money at stake.

It’s all too easy just to take what you’re given. That’s why more than 90% of workplace pension investors end up with their money in the low risk, ‘plain vanilla’ default fund, even when they have many decades of working life ahead of them and could be tens, even hundreds of thousands of pounds better off in retirement if they moved to even a slightly racier fund.

It’s equally easy, if you’re running an ISA or SIPP portfolio, to follow the herd, putting your money into the funds with the highest-profile marketing campaigns, or the success-story stocks in the news. You might make a profitable choice, but it will be a matter of luck rather than judgement.

Successful investing – the sort that is much more likely to transform your financial prospects for the better over the long term – involves an element of homework, and also some discipline. The thousand-dollar question is how best to identify those winning stocks or funds.

 

two types of investment approach

The six most overrated factors in getting rich

There are two key approaches used by investors worldwide. The traditional way is known as fundamental strategy. It involves assessing the investment potential of individual companies by drilling down and analysing their financial reports, business models, quality of management and market prospects.

fundamental investing

A fundamental approach can work well, but investors need time to do their research, and they also need to have a good idea of what they’re looking at. Ideally, they’ll be able to chat directly to company directors in order to understand how the business ticks. It’s what many professional fund managers and analysts spend their working lives doing: expertise and judgement count for a lot.

So as a DIY investor you’ll be at least partly reliant on other people’s legwork. It can be hard work to weigh up the data and the opinions available, or even to understand why the professionals reached the conclusions they did. And there is the ever-present danger that the analysts whose opinions you depend on might actually be overconfident or mistaken in their judgements. They’re only human, after all.

factor or systematic investing

The other strategy – factor or systematic investing – does away with all that subjective opinion and instead relies totally on data. Rather than a ‘bottom up’ approach focusing on particular stocks, it begins at the top with a whole universe of stocks or funds and whittles them down to a bespoke shortlist.

Factor investing is all about numbers, so it uses data on a wide range of metrics to analyse and sift through the stock universe. A factor is any characteristic that helps to explain the long term risk and return performance of a stock. These might include, for instance, measurements of how far a share is overvalued or undervalued, share price performance, future earnings estimates, growth forecasts, dividend payouts, movements in analysts’ estimates over time, and even how a share will react in falling or volatile markets.

In particular there are four key factors that typically sit at the heart of factor investment.

quality

Quality metrics analyse companies’ corporate earnings growth and financial health as a measure of their ability to generate future profits. In effect it’s a way of identifying the ‘best’, most successful businesses.

value

Value ones highlight those companies that are currently moderately valued or even undervalued, selling at a relative premium or bargain price compared to their fundamentals That is likely to be a priority for investors who love a bargain or are anxious not to overpay.

volatility and risk

Low volatility and risk metrics focus on the tendency for the least volatile and sensitve stocks to produce higher risk-adjusted returns than their riskier peers over the long term.

momentum

Finally, momentum is about following market trends, so these metrics shine light on the stocks that are outperforming and popular with other investors as a consequence.

Not only are these factors attractive elements in themselves, but they also work very well together. By combining them when you select stock, factor investors argue, it’s possible to create a range of robust portfolios with great performance potential – and all from the comfort of your own desk.

Dividend Yield

A yield (or high dividend yield) investment strategy gains exposure to companies that appear fairly or undervalued and have demonstrated stable and increasing dividends.

Size

The size factor refers to the empirically verified phenomenon that historically, mid- and small-cap stocks outperform large-cap stocks.

 

how you can get hold of the data

hands holding gold

But this is not the kind of analytical selection process DIY investors could carry out without sophisticated technology at their fingertips, in the shape of dedicated websites. In fact, historically, access to such quantitative analysis was very much the province of professional traders, analysts and managers, and that is still largely the case.

However, there’s a new kid on the factor investing block that could make life much easier for private investors. Aurora is designed to enable ordinary people to set up their investment rules and target the companies and funds that will work best for their needs and risk appetite.

aurora

Be clear: Aurora is not a wealth manager, nor an advisor nor broker. It doesn’t hold your money, and it doesn’t tell you which stocks to buy or sell. It has no vested interests. Rather, it’s a kind of factor-based online toolkit to help you narrow down the stocks and funds worldwide that are most likely to interest you, purely on the basis of the data.

To that end, although the financial analysis used by the website would undoubtedly be pretty impenetrable for most of us, Aurora has reimagined it to create a series of understandable metrics.

Aurora FTSE100 factor analysis

The screen allows you to narrow the universe of forty stock markets, one hundred industries six thousand stocks and fifteen thousand funds, for instance geographically, by company size or industry, or by the size and sustainability of dividend yield. Then you can prioritise the key metrics that are most important to you, whether these are around quality, attractive valuations, dividend risk profile or momentum.

To help keep it relatively simple, a couple of leading metrics work as broad pointers, combining several measures.  The global evaluation metric gives an overall current perspective on an investment, while the star rating metric shows how it ranks in terms of earnings, valuation, momentum and relative performance.

Sorting metrics according to how important they are to you personally produces a broad-based shortlist of the companies with the characteristics you’re looking for. You can then sort further by the range of headings, and click through to read a full explanation of each factor for the stocks or funds you’re most interested in.

Aurora factors

At that point, you might well turn to more in-depth, subjective assessment of the company management team or brand, or fund resources or managerial ability, to make the final cut.

It’s also possible to build a virtual portfolio of the holdings you’re most interested in (or already hold with a broker) and analyse the overall metrics or track changes over time – the data and analysis are updated twice a week. (In contrast, fundamental investors may have to wait for a company’s half-yearly financial report to see the latest figures.)

Importantly, Aurora takes no jargon for granted. Investment geeks are all too often guilty of assuming everyone understands the technical terms – or worse still, explaining them in equally jargon-ridden language – but that’s not the case here, There’s a huge amount of information to digest, but it’s presented accessibly, with transparent explanations and a comprehensive glossary if you get stuck.

Even better, MoneyMagpie readers can get an exclusive 20% off Aurora when they use the discount code: moneymagpie 

After the two week free trial, the discount will kick in.

So sign-up today.

 

is factor investing (systematic investing) for you?

So could factor investing work for you as a long-term investor? Well, you’ll have to be prepared to put a bit of effort into understanding the various factors and what they can tell you about a stock, but if you want to do a thorough, disciplined job, it’s an obvious next step.

Factor investing can be quick, efficient and adaptable – a great foundation from which to build a global portfolio that does what it says on the tin. Crucially, it removes the emotional bias and makes the process of stock or fund selection a much more scientific process.

It’s important to recognise, though, that it’s not ‘superior’ to fundamental investing – the two can work well in tandem, with  aspects such as the fund manager’s track record or analyst recommendations brought in to help identify the all-round winners from your data-driven shortlist.

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This is not financial or investment advice. Remember to do your own research and speak to a professional advisor before parting with any money.

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