Factor investing is a subset of computer driven quantitative investing and, technically speaking, has been around since the 1930’s when Benjamin Graham and David Dodd introduced the concept of value investing. Although value was only dubbed a ‘factor’ in the past few years, the observation that specific factors behave in certain ways predates the attempts at the comprehensive explanations put forward in recent years. Big data, artificial intelligence and powerful computing capacity are now being applied to a variety of ‘factors’ and this has come to be known as factor investing.
What Are These Factors?
A factor is defined as an observable and quantifiable characteristic to which differences in return can be attributed. Given this definition there can be dozens of factors. That said, the top five are:
- Value, which is the tendency for relatively cheap securities to outperform relatively expensive ones
- Momentum, which is rooted in the fact that assets with a positive trend tend to continue on that trajectory and those that are falling usually continue their downward slide
- Quality suggests that low risk, safe companies tend to outperform riskier, heavily indebted companies
- Volatility is based on the premise that stocks with muted movement, over time, will outperform more volatile offerings
- Size refers to the fact that small cap companies tend to perform better than large caps over the long term
This Doesn’t Appear to Be Anything New
That’s true. Factor investing has been part of the hedge fund industry for decades and, while it is true that factor investing is nothing new, the application of artificial intelligence, in combination with big data and super-computing power, has forever changed the way factors are analyzed and quantified.
Consider Google’s 2008 launch of its service designed to predict influenza outbreaks via an examination of internet search terms. If Google saw a rise in the number of individuals searching terms that related to the flu, it was considered an indication that a flu outbreak was in the works. Initially, the system appeared to work better and faster than conventional health statistics. After a few years, it became apparent that the system was not accurate and Google has since suspended the service.
In the same way, it may be dangerous to place too much trust in big data analysis by artificial intelligence algorithms…just saying.
How Does Factor Investing Threaten Hedge Funds?
The argument put forward in a recent Financial Times article is that if someone develops viable software that targets the correct factors, any number of investment firms could use it to make successful plays for its investors, thus minimizing the appeal of hedge funds.
This is highly unlikely to be the outcome for 2 obvious reasons. The first is that hedge fund firms could and most certainly would employ the same systems for the benefit of their investors. Second, it is beyond reason to assume that such a system would enjoy widespread acceptance given the specter of the Google experience with regard to predicting flu outbreaks.
No prudent investor would place all his eggs in such a basket.