Below is an adaptation of the most recent article I wrote for the Australian Financial Review which was published today (08/02) on page 24 and appears online here . I have made some extra additions to provide Stockopedia members with further context and education.
How to use factor investing to chase the better returns
Blending the styles is a way to help smooth out factor-driven cycles.
A key question for investors over time is, “What drives investment returns?”
A seminal work by Eugene Fama and Kenneth French in 1992 – The Cross-Section of Expected Stock Returns – offered a solution. Without going into too much detail, the net outcome of their findings was that stocks exhibiting particular traits could have different average returns, and thus different drivers and expectations of performance.
This contrasted with the previous thinking that all stocks should have the same expected returns. Referred to as the Capital Asset Pricing Model (CAPM) as it came to be known, it was believed that it was not possible to outperform the market. Rather it was a stock’s beta (its tendency to vary from the market) which caused the variation of returns.
Through their research Fama and French created a three factor model that expanded this previously restrictive model by proving that adding the factors of size and value into what became known as their “Three-Factor model” could explain differences in a diversified portfolio’s returns.
The net outcome of Fama and French’s findings was to turn the previous thinking surrounding expected returns on its head, and the concept of “style investing” was born. Today it is more commonly known as “factor investing”, a strategy to identify and exploit systematic patterns in the returns of different securities.
However, it would be wrong to assume investors weren’t using factors to help identify stocks in the past. Throughout the 20th century, famous investors such as Benjamin Graham, often referred to as the “father of value investing”, used value measures to identify cheap stocks believing that investing in stocks that exhibited that style would generate consistent above average returns..
Then there were others such as his most famous student Warren Buffett, who added quality traits to his screens in order to find quality at reasonable prices. On the other end of the spectrum, there was Richard Driehaus, who…
