What is factor investing?
Factor investing refers to an investment strategy that chooses stocks based on certain quantitative “factors”. These “factors” have historically demonstrated high returns.
Unlike Fundamental analysis, which involves many quantitative and qualitative factors and typically requires a deep understanding of the business – Factor investing identifies a few metrics that can potentially predict high returns.
For example, if you found out that strawberries which are longer and less bulgy on average are sweeter, you would apply this selection “factor” to end up with a winning basket of sweet strawberries. A nice little shortcut.
Correlation is not Causation
A study by Tyler Vigen showed a high correlation (0.99) between per capita consumption of Margarine in Maine and the divorce rate in that state! Can we conclude that margarine consumption leads to marital discord? Probably not!
Factor investing is also susceptible to this – but there are some factors that have shown very long history of correlation with high returns. And these returns were seen in different markets. One of the most persisting factors is “Momentum”
What is momentum investing?
This factor identifies stocks that have shown significant price increases over a certain period, with the expectation that these trends will continue in the short term. So like the term “momentum” suggests – The price trend is expected to continue.
Intuitively, this can be attributed to herd mentality – investors piling into stocks that are rising. Another common explanation is that good news takes a long time to be discovered and reflected in stock prices. A company that is driving costs down and attracting more customers through the door – will see a gradual uptick in earnings. This delayed reflection in results will slowly start attracting attention from discerning investors driving prices up.
Does it work?
The Nifty 200 Momentum 30 has increased 35 times versus the Nifty index at 11 times (source). It is worth noting that momentum is classified as a risk strategy. During market downturns, the momentum strategy underperforms the index (larger drawdowns).
The above graph is calculated from the annual returns table here.