Factor investing

Factor investing is a strategy that is using quantifiable characteristics or “factors” with the hope of achieving higher returns. The portfolio is weighted with different keys/attributes than classic market capitalization. Factor investing is the most popular among equities; however, more and more factors (systematic characteristics) are also discovered in other asset classes. 

Macroeconomic factors and style factors are two main types of factors that have driven returns of stocks, bonds, commodities, and other assets. Macroeconomic factors capture broad risks across asset classes, while style factors aim to explain returns and risks within asset classes. An investment strategy involves tilting equity portfolios away and towards specific factors to generate long-term investment gains in excess of benchmarks. The method is quantitative and based on observable data, such as stock prices and information from financial statements, rather than on opinion or speculation.

There are a lot of factor premia uncovered in equities; the best known are value (book-to-market) factor, momentum effect in stocks, low volatility effect, and quality and investment factors. Most of them are not limited only to one asset class. You can find the momentum effect in commodities, currency momentum, and even momentum in bonds, and it is the same as the other factors.

One more important feature of factors is their significant time-variation. Some factor premia are even mildly predictable as several notable academic papers show (Glabadanidis: Market Timing with Moving Averages, Bakshi, Panayotov: Predictability of Currency Carry Trades or Zakamouline: Predicting the Small Stock Premium Over Different Horizons) which offers an opportunity to build market timing strategies based on a factor timing. 

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The Encyclopedia of Quantitative Trading Strategies

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