Factor investing is a popular investment approach that aims to identify and exploit specific risk factors that drive returns in financial markets. It is based on the belief that certain characteristics or factors, can explain a significant portion of the variability in asset returns. These factors can include things like a company's quality, value, profitability, volatility, and momentum. By targeting these factors, investors can potentially achieve higher returns and better risk-adjusted performance than traditional market-cap-weighted strategies.
Factor investing can be applied to various asset classes, including equity and fixed income. In equity markets, for example, investors can use factor-based strategies to tilt their portfolios towards stocks with specific characteristics, such as those that are undervalued, have positive momentum, or exhibit low volatility. In fixed-income markets, factor investing can be used to target specific risk factors, such as credit risk, interest rate risk, and quality risk.
First, we look at long-term technical charts to determine which end of the spectrum for a factor is the right choice. For example, high-quality vs low-quality companies. We then have a proprietary scoring system that we use to determine if we have strong or week confidence that which end of the spectrum we should be on. Once we have strong confidence, we then use regression analysis to determine which investment returns are statistically being driven by the desired factor. We then use a forward-looking efficiency curve to assign a portfolio weight to each investment. The forward efficiency curve is a graphical depiction of the anticipated excess returns of a financial asset. The forward efficiency curve is commonly used in asset allocation and portfolio management to gauge the predicted risk-adjusted returns of different investment opportunities at varying time horizons.
Let's take a closer look to see how we do it.
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