Factor Investing | An Introductory Guide

Factor investing involves asking investors to select the most important qualities in stocks they purchase and organize the holdings in their portfolios accordingly.

If you tend to gravitate towards growth rather than value stocks, high-momentum versus low-momentum equities, or large-cap over small-cap companies, you are a factor investor. Factor investing is just the selection and prioritization of equities based on one or more chosen qualities — also known as “factors” — and use them to create an optimal portfolio with minimal risk and maximal returns.

This style of investing is on the rise in recent years as more successful funds allocate their capital according to factor-based models. The factors prioritized can range from value to momentum to size or many other underlying qualities. Factor investing is then less of a specific strategy and more of an overarching philosophy of investing. It simply argues that risk and returns can be optimized by choosing securities based on a few key attributes tied to good performance.

Factor Investing Aims to Manage Risk and Diversify Assets Without Sacrificing Returns

Going “all in” on any particular equity is rarely a good idea — while it is possible to make great returns with a few lucky investments, the risk associated with this strategy is astronomical. Smart investors instead can opt to minimize risk by choosing to diversify their portfolio. This is done by allocating their money to multiple equities, markets, asset classes and other distinguishing factors so that any unforeseen loss is far less decimating.

However, if the supposedly diverse assets move in lockstep with the greater market, virtually all of the gains of diversification are lost. This is a common mistake made by new investors — they mean well by attempting to diversify their portfolio, but often distribute their capital among stocks and bonds that rise and fall in tandem.

As an example, some young investors will concentrate nearly all of their money in the five most popular technology stocks: Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Apple (NASDAQ:AAPL), Netflix (NASDAQ:NFLX) and Alphabet (NASDAQ:GOOG), also known as the FAANG stocks. Since all five of these companies respond to stock market conditions in the same way, however, splitting capital among them does very little to minimize risk and reap the benefits of diversification.

Factor investing offers a solution: by selecting companies based on distinguishing factors that are reliable predictors of returns, investors can diversify in a more meaningful way without sacrificing profitability. Knowing which factors to concentrate your portfolio on can then inform smarter diversification decisions, both within and across asset classes.

Factor Investing is Driven by Two Main Types of Factors

There are two primary categories acknowledged by factor investors: macroeconomic factors and style factors.

Macroeconomic factors address broad risks across multiple asset classes. They can include economic growth as a result of exposure to the business cycle, interest-rate movement, unemployment and inflation or exposure to changes in prices. Other common macroeconomic factors are credit risk, liquidity and political risks of emerging markets.

But risk from the greater market cannot fully encompass how safe or bold a given investment is. That’s why we also use style factors, which capture risk and returns within asset classes. Popular style factors are value (how much a stock is discounted relative to its fundamentals), volatility, momentum and size. Investors and funds evaluating style factors also frequently look at financial health and income incentives to hold riskier securities.

These style factors are often acknowledged in smart beta investing strategies. This kind of factor investing focuses on the mathematical data used to predict value, volatility, size, quality, momentum, beta and other equity-specific metrics. It then attempts to use this data to redistribute capital in a more optimal way than typical index funds.

Factor investing as a whole, however, will typically use a mix of style factors and macroeconomic factors in search of an optimally diversified portfolio. Some funds will focus only on smart beta and style factors while others will put more emphasis on greater market conditions. How much weight is given to each individual factor will differ from one investor to the next.

Some Factors Allow Investors and Fund Managers to Beat the Market

Investors interested in factor investing are looking for the specific factors that, when tracked effectively, allow them to consistently outperform the S&P 500.

For example: there is some evidence that low-volatility stocks tend to outperform the market in the long-term. Investing in primarily low-volatility stocks, however, eliminates the potential gains brought on by big, market-moving, risky stocks.

A more common factor for mutual funds and exchange-traded funds (ETFs) to focus on is momentum. Momentum-based funds select stocks to diversify their portfolios by using recent performance, and, when well-managed, tend to perform very well. Shown below are three of the most popular momentum-based factor investing funds charted with the S&P 500 as a baseline (the horizontal red line).

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We can see that these kinds of funds are frequently above the baseline, meaning they outperform the market and have a positive alpha.

The Most Famous Example of Factor Investing is the Fama-French 3-Factor Model

Before we can understand multi-factor models, we need to introduce the capital asset pricing model — CAPM, for short — a formula for calculating the expected returns of an asset given its risk. CAPM takes into account the risk-free rate, beta and a market risk premium to estimate the return on investment for any given equity.

Multi-factor models often expand on this. Developed by Fama and French in 1992, the Fama-French 3-Factor Model is an extension of CAPM that accounts for a few additional variables: book-to-market value, excess returns and size. Fama and French built an econometric regression from historical stock prices to find that small-cap stocks and value stocks tend to outperform larger growth stocks in the long term — they were awarded a Nobel Prize for their research later in the 1990s.

Taking these factors into account means prioritizing small-cap, value stocks in diversification and stock selection. Investors using the Fama-French 3-Factor Model, if the mathematical data carries into application, can expect increased returns over a 15 year horizon.

Most funds using a factor investing strategy operate in a similar way: they select a few macroeconomic or style factors that they believe will increase returns, and adjust their portfolio accordingly. The original model developed by Fama and French only considered three primary factors, but a modern update of the same model now uses five. The Fama-French 5-Factor Model uses the original three factors (book-to-market value, excess returns and size) as well as predicted future earnings and internal investment. Other variations on the system may include momentum, quality, low volatility or other similar factors to boot.

Many ETFs Employ Factor Investing Strategies

Applying factor investing strategies in your own portfolio can be powerful but time-consuming. Many exchange-traded funds, however, already employ these principles. Listed below are some of the best ETFs focused on factor investing:

Factor Investing Lets Investors Organize a Portfolio According to What They Care About Most

While some portfolios inspired by factor investing strategies will be riddled with complex statistical models, others are a conglomerate of stocks and equities chosen because they share some common quality. Factor investing, as a whole, has risen more and more in popularity as the technology to track factors becomes accessible both to fund managers and the general public.

Regardless of their complexity, factor investing strategies help savvy investors diversify and organize their portfolios to maximize profit with minimal risk taken. For additional information on factor investing and similar strategies, read our articles on momentum investing and smart beta investing.

Jonathan Wolfgram is an editorial staffer who writes website content at Eagle Financial Publications. He graduated from the University of Minnesota with Bachelor’s degrees in Finance and Philosophy. Jonathan writes for www.DividendInvestor.com and www.StockInvestor.com.