Risk-based explanations for the quality factor include the concept that profitable firms experience various dynamics that require a risk-premium to be placed on them by investors.
For example, profitable firms may attract greater competition due to the potential for greater profits by new market entrants. This increases uncertainty, leading to investors placing a risk-premium on such firms.
Behavioural-based explanations for the quality factor include the idea that investors may expect that the prices of profitable firms to mean-revert faster than they actually do, which can lead to premature selling.
Stated another way, investors might find it psychologically preferable to back the revival of unprofitable firms, rather than to expect continued strength in profitable firms.
Minimum volatility
The minimum volatility factor focuses on securities with lower volatility compared with their peers.
Through this prioritisation of less volatile securities, the minimum volatility factor is inherently defensive in nature and can outperform in recessionary environments, compared with the wider market.
However, risk-based explanations for the minimum volatility factor break down, as the idea that minimum volatility securities have a premium is counterintuitive to conventional investment thinking, which suggests higher rewards are inextricably linked with higher risk.
This leaves us with behavioural-based explanations for the factor.
For example, we frequently see investors display signs of overconfidence, which can lead to sub-optimal investing, such as overpaying for attention-grabbing (volatile) securities.
Alongside this we may see such securities generate significant media coverage, leading to increased volatility, and generating demand that leads to further overvaluation.
Additionally, we see investor characteristics such as skewness preference, with investors preferring the lottery-like payoffs of high-volatility securities, which have the possibility of large returns.
This can lead to a premium for higher volatility securities that is not warranted by fundamentals.
In summary, factor investing is an investment approach that involves targeting quantifiable factors that can explain differences in security returns, tilting a portfolio towards or away from these factors in order to generate additional return or reduced risk.
Quality and Minimum Volatility are two of the five most widely accepted factors, with their focus on profitable and resilient companies, and lower volatility securities, respectively.
These two factors have typically performed well in economic downturns, and they play a core role as part of a diversified factor-based portfolio.
In the next article in the series we will go on to explore other factors in the factor investing toolkit, and how these can add value as part of a diversified factor-based approach.
Jonathan Griffiths is investment product manager at ebi
