Investors are always looking for the next edge to help them maximize gains and beat the market.
One of the more popular trends recently in this arena has been factor investing. This strategy has been around for decades, and it has been drawing increasing interest in recent years.
Investors are increasingly interested in learning more about how factor investing compares to other ways of investing, like actively hand-picking stocks or trying to time the market.
What is Factor Investing?
Factor investing offers a more calculated way to design a portfolio that can outperform the broader market. It bases investment decisions on the factors that are common among high-performing securities by including only those with these driving characteristics.
Also referred to as “smart beta” investing, factor investing identifies buying opportunities based on whether the security has the right type of quantifiable factors. It’s a statistical approach to building a portfolio. (Although technically “smart beta” is just one application of factor investing.)
Investors use factors to help them develop a portfolio to beat the market without going through the process of stock picking.
Two of the more popular factors shared across a set of securities are the size and value of a security. Analysis has shown that, in general, small cap stocks tend to outperform larger ones and value stocks tend to outperform growth stocks over time. Other common factors considered include momentum, low-volatility, and quality.
Key Factors in Factor Investing
Size
Smaller cap stocks have been found to outperform larger cap stocks over time. The idea is that smaller stocks have more risk, so investors expect more reward.
Value
Value stocks are those that are trading at a discount, or lower price. Some investors may perceive these stocks as questionable, but the idea behind value investing is that these are the stocks that can yield the most gains because they are undervalued. It was a factor Warren Buffett appreciated – that value stocks beat the market over time, outperforming growth stocks.
Momentum
When a stock has positive momentum, it’s enjoying a positive price trend. The idea behind this factor is that a rallying stock generates more interest from investors who don’t want to miss out on more gains. So, momentum stocks tend to perform well.
Low-Volatility
Stocks with lower volatility, those with less dramatic price swings, tend to outperform. Of course, while that’s the case on average in the long-run, that’s not always the case. Sometimes, such as in significant market rallies, high volatility stocks outperform lower volatility ones.
Quality
The definition of “quality” can vary. Stocks with greater profit margins, reliable earnings, better cash flow, and lower debt than their competitors are typically considered higher quality. Higher quality stocks do tend to outperform the market over time.
Over the years, analysts have identified hundreds of factors that can affect a stock’s performance, some being more reliable than others.
How Factor Investing Works
Factor investing, on the surface, is straightforward. It is simply building a portfolio that includes stocks with particular characteristics shared by other stocks achieving competitive gains.
One common way average investors easily participate in factor investing is by buying shares of an Exchange-Traded Fund (EFT) that focuses on a particular factor. For example, you can buy shares of an ETF that holds small cap stocks.
To be considered a factor, the driving force needs to be identifiable over time, not limited to particular time periods (although they can be cyclical).
And it needs to apply to stocks across all sectors and in all regions. In other words, specific industries, sectors and locations should not have an impact on whether the factor is a driving force.
How Factor Investing Relates to Investment Goals
The best strategy of investing for you depends on your own personal financial situation, investment goals and risk tolerance. Factor investing is in general a good strategy for long-term investors because the driving forces are identified as helping stocks beat the market over a longer time horizon.
Factor investing can help you meet a variety of investment goals, but its primarily ideal for those trying to maximize returns while reducing risks. It aims to help investors improve their returns while reducing volatility and increasing diversity. It is an alternative strategy to trying to time buying investment to the market and hand-choosing them.
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What is Multi-Factor Investing?
Just as the term implies, multi-factor investing is a form of factor investing that uses more than one trait in the stock selection process.
Generally, factors are not correlated with one another, and pay off at different times. So, investors can expose themselves to multiple factors to increase diversity.
There are two ways to go about developing a diversified portfolio with the multi-factor investing approach. The first is to screen stocks for each of the factors, and include a mix of those stocks that have a factor in the portfolio. A second approach, which sets a higher bar for stock selection.
Many investors favor a multi-factor approach because it allows them to diversify, and benefit from the rewards of more than one factor. This makes sense when you consider the fact that the driving force of the factors are cyclical, varying depending on the economic environment.
How Factor Investing Is Gaining Popularity
Factor investing is indeed gaining more attention with the rise of new technologies that can take advantage of its strategy.
Many Exchange-Traded Funds (ETFs), which are like mutual funds but trade shares over an exchange platform, are using factor investing to create their “smart beta” funds. Now, more than $900 billion is invested in about 820 ETFS that use factor investing to make investment decisions, according to FactSet data cited by MarketWatch.
In fact, the success of many active fund managers who regularly beat the market can be increasingly explained by the factors common in the securities in their portfolio, not by the fund manager’s stock-picking skill.
For investors, that means they can achieve those same returns through a factor ETF and avoid the costly service of active fund managers. For example, if an active fund manager’s fund was performing well with a slate of small cap stocks, an ETF’s holdings could easily replicate the success based on that factor.
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The Bottom Line
Factor investing is one of the hottest trends in investing strategies. It’s at the forefront of market research these days as more investment firms adopt the practice.
But, as with any investing strategy, this method is not for everyone. And it does not guarantee success. Keep in mind that, at least right now, there is no perfect factor model.
Factor investing through index funds has the potential to match the returns of an active fund manager at a fraction of the cost. So, this strategy could save investors significant money through fees and commissions over the long-term.
Any strategy that aims for market-beating returns while maintaining lower risk is likely to attract attention for years to come.
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