When it comes to investment portfolios, not everything is created equal. When it comes to assets in a factor-based portfolio, not all are weighted equally, and that is exactly the point.
Factor-based investing isn’t a new idea, but these days, it has a new, broader appeal. More and more, it’s helping investors customize their investment goals and better build their portfolios to achieve that end.
According to Morningstar Inc., as of 2018 nearly $800 billion was invested in almost 1,500 factor-based exchange-traded products. This was an increase of approximately $700 billion from the previous year.
Factor-investing has traditionally been a tool for institutional investors. According to Invesco’s Global Factor Investing Survey, over 70% of institutional investors surveyed in 2018 were using factor strategies. But, now more than ever, private investors are realizing its benefits and getting on board. Here’s why you should consider it.
What is factor-based investing?
As a rule, investors generally look for excess return and reduced risk in their assets. Factor-based investing not only acknowledges this, it carefully weighs the characteristics associated with both higher returns and lower risk.
Factor-based investing grew in large part out of academic concepts that provided a systematic approach for investors. Eugene F. Fama won the Nobel Prize in Economics in 2013 for his work on research on market efficiency, which sought to determine how to make returns other than by beating the market. He and his research partner, Kenneth R. French, developed “The Fama and French Three-Factor Model” in 1992 which helps investors to more strategically diversify their portfolios.
Factor-based investing is an alternative method of investing that seeks specific outcomes that pertain to return enhancement, risk reduction, and diversification of income. It can effectively complement both traditional active and pure passive investing.
What ‘factors’ matter to investors?
Factors are the “broad, persistent drivers of returns across asset classes.”
The two primary classes of factors are “macroeconomic factors, which capture broad risks across asset classes; and style factors, which help to explain returns and risk within asset classes.”
According to BlackRock, macroeconomic factors include economic growth (exposure to the business cycle), real rates (the risk of interest-rate movements), inflation (exposure to changes in price), credit (default risk from lending to companies), emerging markets (political and sovereign risks), and liquidity (holding illiquid assets).
Also according to BlackRock, style factors include value (seeking stocks that are under-valued), minimum volatility (seeking historically stable, lower-risk stocks), momentum (seeking stocks with upward price trends), quality (seeking companies with steady earnings and consistent returns), size (smaller, high-growth companies) and carry (income incentives to hold riskier securities).
These factors are not absolute. FTSE Russell and Invesco both also include dividend yield as factors. Research Affiliates includes income. In fact, there are upwards of 200 factors.
Why consider factor-based investing
Factor-based investing increases transparency as well as control for private investors. By identifying “underlying return drivers” for various factors, it helps investors to better understand how their portfolios are meant to achieve their specific financial goals. Factors that affect bonds include interest rates, inflation, and credit ratings, for example.
And, investors don’t have to be all in or out. Investing with consideration of factors is designed to help further specific outcomes, such as reducing volatility or enhancing diversification. What that means for investors is that they can pick and choose which will further their goals and which to leave at the door.
For example, someone nearing retirement may want to reduce risk, whereas another younger investor early in their career might want to focus on increasing returns with less regard for risk. The myriad of available factors and investment firm approaches using the same framework allows investors to pick and choose how to diversify their portfolio based on their needs.
The scientific-based research on factor-based investing is in many ways changing the role of a financial adviser and appealing to a broader swath of private investors. Not only does it give investors a more informed framework to make decisions from, it gives financial investors a fuller picture of both client needs and options.
Another perk of factor-based investing is that it acknowledges the fact that not all factors will perform the same at the same time. In factor-based investing, that’s perfectly okay.
Factor-based investing considers how assets will perform over time, making it a wise part of a long-term investing plan. Extrapolated over a lengthy period of time, a factor-based portfolio may outperform, but can also underperform traditional portfolios.
Factor-investing is not one-size fits all. Rather, it’s more like a map that asks what where an investor would like to go (namely: what are his/her financial goals?) and then helps that investor to determine which assets to select to get there.
