Factor Investing: For Those Who Embrace the Risks

Factor investing is an investment approach that selects securities based on factors historically linked with high returns and lowered risk. In particular, factor investing provides a targeted method to enhance diversification and mitigate losses due to asset correlation.  

The roots of factor investing trace back to the famous 1934 book Security Analysis, in which the authors explored factor-related analysis in active fund management. (What a mouthful!) But it wasn’t until the 1960s that the first prototype for factor analysis appeared: the Capital Asset Pricing Model (CAPM), which described the relationship between risk and expected return.

Since then, factor analysis has grown into a robust body of research involving hundreds of potential factors and multi-factor strategies. While the approaches may vary, the goal of each is the same: to increase diversification, generate higher returns, and reduce risk.

What is Factor Investing?

Think of factor investing like a filter for potential securities. You start by selecting a factor, such as low volatility, value, or momentum. Then, you pour prospective investments in – and see what filters into your portfolio.

In this way, factor investing allows investors to either streamline their portfolios toward specific outcomes or target broader – but still well-defined – goals.

For instance, if you’re saving for retirement, a broad-strokes strategy might seek increased dividends and low volatility. On the other hand, an investor looking to make a down payment on a house in 10 years may try to beat the S&P 500’s performance by 15% annually.

Regardless of the specifics of your desired outcome, the overarching goals of factor investing often remain the same:

  • Outperform the broader market
  • Enhance or contribute to diversification strategies
  • Control or reduce risks
  • Lower overall portfolio costs

The “Factors” of Investing

There are literally hundreds of factors you can consider in building a factor investing strategy. These range from broad economic influences such as a country’s GPD, to more granular factors like a company’s credit rating or market capitalization.

But we won’t even come close to discussing all of them here. Instead, we’re going to cover the “big five” systematic factors upon which many factor approaches are founded.

  • A value approach aims to capture returns from undervalued stocks. Typically, you measure value by tracking dividends, free cash flow, and the price-to-book or price-to-earnings ratios.
  • Momentum approaches filter out those securities that outperform the market in the past three to twelve months – while tossing the underperformers by the wayside. 
  • Weeding out companies by size helps you determine which stocks have greater growth potential according to a company’s market capitalization. (Hint: small-cap stocks have more room to increase returns.) However, smaller companies generate higher returns at the expense of higher risk.
  • Low volatility securities tend to yield greater risk-adjusted returns than high-volatility assets (though, admittedly, they’re less exciting). One of the most common ways to capture beta (estimate risk) is by measuring the standard deviation over the past one to three years.
  • Quality is assessed by common financial metrics such as debt-to-equity, earnings viability, and return-to-equity. Simply put, companies that generate superior profits, maintain low debt, and demonstrate strong corporate governance often prove more consistent in the long-term.

An investor may adopt any or all of these as a viable investment strategy. In factor, the best-performing portfolios (in the long-term) often take a multi-factor approach to account for (and profit from) cyclical economic performance. A multi-factor approach can also neutralize risk, further enhance diversification, minimize correlation, and increase profit potential.

Factor Investing Returns

It’s worth noting that (very) long-term factor strategies often produce above-average returns by reducing correlation and increasing diversification. While a diversified portfolio is one of the best ways to minimize losses, even a well-diversified portfolio imbues some risk of unidentified bias, leading to whole portfolios moving with the broader market.

Factor investing is designed to offset these risks in the very long-term by targeting investments with strong performance histories. However, the nature of factor investment means that short- and medium-term investors see increased price volatility and fluctuating returns.

In fact, while we’ve noted repeatedly that these funds intend to reduce risk, the term is somewhat subjective – factor investing seeks to reduce risk against investments of a particular type, rather than the broader market. In fact, many factor investment strategies carry significantly more risk than investing in a fund that tracks the S&P 500.  

This is, at least in part, because the various components of factor investing are often fundamentally juxtaposed, leading to cyclical performance and severe dips in profits.

For example, let’s say you select value, momentum, and quality as your three-pronged investment strategy. Typically, value investors buy declining stocks, while momentum investors go for rapidly rising stocks. Quality investors straddle somewhere in the middle, with stocks backed by strong fundamental performance. Incorporating all three factors in one portfolio provides investors a chance to take advantage of different phases of the economic cycle:

  • Small-cap and value stocks often generate higher returns during periods of weak or accelerating growth
  • In times of crisis, low-volatility and quality securities may leapfrog ahead of their value counterparts
  • Momentum investing provides investors with a way to take advantage of any stocks that are currently performing well – while shedding underperformers in the meantime

Why Factor Investing?

Now that we better understand factor investing, you might ask: why? What makes this approach superior to (or different from) a more traditional stock screening process?

The answer boils down to the objectivity of the selection process itself.

When building a portfolio or investment fund, investors and fund managers often select securities by applying specific – and internal – goals. This process leads to investors using their unique insight, skills, or information, as well as their own judgement.

At the same time, the internal selection criteria often require hours of stock-specific research and subjective decision-making on which securities make the grade. As a result, selecting stocks by hand according to this blanket approach can lead to unintended biases or asset concentrations, be it by sector, market cap, or the company CEO’s last name.

Factor investing aims to remove unintended biases and subjective judgment calls in favor of a rules-based approach. Instead of picking strategies that fit your stock selection, you’re screening stocks by strategy. Stocks that meet the baseline characteristics based on objective, quantitative data and performance make the cut – and everything else falls by the wayside.

Done correctly, a multi-factor investment strategy can lead to broader diversification, lower security-specific risk over extended timeframes, and the potential for greater long-term profits.

Getting Started with Factor Investing as a Retail Investor

Until quite recently, factor investing involved parsing through hundreds of factors by hand to find the perfect investment model. Furthermore, most factor models are inherently very risky in short- and medium-term timeframes, with increased volatility leading to (hopefully) temporary reductions in profits.

As such, factor investing has typically been the domain of institutional investors and fund managers with the time and resources to build, analyze, and implement extensive factor strategies in lieu of traditional approaches – and wait out poor economic cycles when they occur.

But the internet has changed the investment landscape dramatically. Modern retail investors enjoy unprecedented access to data, tools, spreadsheets, and a plethora of preexisting factor investment models. Now, it’s easier than ever to gather and analyze complex financial data – though, admittedly, there’s still a lot to sift through.

Beginning factor investors who find themselves flustered by the sheer number of options may decide to opt for a rules-based ETF or actively managed fund that follows factor investment strategies, such as the:

  • iShares MSCI USA Min Vol Factor ETF
  • iShares MSCI USA Value Factor ETF
  • iShares MSCI USA Momentum Factor ETF

Alternatively, investors who do their due diligence may enjoy building a portfolio based on any number of factors or multi-factored approaches. If this sounds like you, it may be best to start small, with fewer and simpler elements at first, such as growth, size, risk, and returns. Over time, as you grow comfortable with your risk and abilities, you may add or revise your factors as you see fit.

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