Investors have long been searching for ways to outperform the market, and factor-based investing, also known as smart beta, is one strategy that has gained popularity in recent years.
Unlike traditional investing, which simply tracks a market index, factor-based investing targets specific factors or characteristics that drive returns, such as value, momentum, or low volatility. Investors can achieve better returns by selecting stocks with these characteristics than investing in the broader market.
But what exactly is factor-based investing, and how does it work?
This guide will explore the critical concepts of factor-based investing and its potential advantages and risks.
Whether you’re a seasoned investor or just getting started, understanding the basics of factor-based investing can help you make more informed investment decisions and achieve better outcomes over the long term.
What is Factor-based investing?
Factor-based investing is a strategy that involves selecting stocks based on specific characteristics, or factors believed to drive their returns. These factors include company size, value, momentum, quality, and volatility.
For example, a value strategy would involve selecting stocks trading at a discount relative to their intrinsic value. A momentum strategy would involve selecting stocks with a recent solid performance that are likely to continue performing well.
For example, the value, momentum, and quality factor-based portfolios outperformed the broader market (S&P 500) from 1992 to 2021, while the low volatility portfolio underperformed.
This suggests that investors exposed to these factors could have achieved better returns than those who simply invested in the market as a whole.
History of Factor-based investing
Factor-based investing has its roots in the work of pioneering economists and finance theorists who sought to understand the factors that drive stock market returns.
1. 1960s and 1970s: Birth of Efficient Market Hypothesis
One of the earliest proponents of factor-based investing was Eugene Fama, who developed the Efficient Market Hypothesis in the 1960s and 1970s. It arges that all available information is already reflected in stock prices.
This theory led to passive investing, where investors aim to capture market returns by investing in broad-based indexes like the S&P 500.
2. 1990s: Birth of Factor-Based Investing
In the 1990s, academics like Ken French and John Cochrane began to challenge the Efficient Market Hypothesis by showing that certain factors, such as value and momentum, could explain a significant portion of stock market returns. This led to the development of factor-based investing strategies, where investors focus on these specific factors to achieve better returns than the broader market.
Factor-based investing has become increasingly popular among institutional and retail investors, with billions of dollars flowing into factor-based funds and ETFs.
While the strategy has not been without its challenges, including the risk of overfitting and the difficulty of identifying the best factors for a given market environment, it has become an essential tool for investors seeking to achieve specific investment goals.
Difference between Traditional and Factor-Based Investing
Traditional and factor-based investing differ in several ways, including their approach to selecting investments, their focus on risk management, and their expected returns.
1. Way of Analysing Investment Opportunities
One of the main differences between the two approaches is how they select investments.
For example, traditional investing typically involves selecting stocks based on their company’s financial fundamentals, such as earnings, revenue growth, and overall economic outlook. Factor-based investing, on the other hand, focuses on specific characteristics or factors that are believed to drive returns, such as value, momentum, and quality.
2. Risk Management
Traditional investing often relies on diversification or investing in various stocks and asset classes to spread risk.
On the other hand, factor-based investing may use a more targeted approach to risk management, such as selecting stocks with low volatility or high-quality financials.
3. Expected Returns
Traditional investing generally aims to achieve returns in line with the broader market.
In contrast, factor-based investing may aim to outperform the market by selecting stocks with specific characteristics expected to drive outperformance.
Overall, both traditional and factor-based investing have their strengths and weaknesses. The best approach for a given investor will depend on their investment goals, risk tolerance, and investment horizon.
Factors used in Factor-based investing
Factor-based investing involves targeting specific characteristics, or factors, that are believed to drive stock market returns.
These factors can include a wide range of features, but some of the most commonly used factors include,
The value factor aims to capture excess returns from stocks with low prices relative to their fundamental value. This can be tracked using metrics such as price to earnings, price to book, free cash flow, and dividends.
The momentum factor suggests that stocks that have outperformed in the past tend to bring strong returns in the future. To employ a momentum strategy, investors look at relative returns over a period of three to 12 months.
The quality factor can incorporate stable earnings, low debt, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by analyzing common financial metrics such as debt to equity, earnings variability, and return on equity.
The volatility factor suggests that stocks with low volatility earn higher risk-adjusted returns than more volatile assets. This can be measured by capturing beta, or a typical deviation from a one to three year time frame.
The size factor suggests that portfolios consisting of small-cap stocks historically show greater returns than ones made up of only large-cap stocks. To capture this factor, investors can look at the market capitalization of a stock.
Advantages of Factor-Based Investing
Factor-based investing offers several potential advantages for investors.
1. Improve Returns
First, factor-based strategies can improve returns by targeting specific characteristics that are believed to drive higher performance. Investors may achieve better returns by selecting stocks with these characteristics than investing in the broader market.
2. Diversification Benefits
Second, factor-based investing can offer diversification benefits by targeting factors that are not highly correlated with each other. This can reduce risk and increase the stability of returns over the long term.
3. Better Risk Management
Third, factor-based investing can provide a more targeted approach to risk management by focusing on specific factors expected to perform well in different market environments.
For example, a low volatility factor strategy may be more defensive in a market downturn. In contrast, a momentum factor strategy may perform well in a rising market.
4. Higher Transparency
Finally, factor-based strategies are often implemented using rules-based, transparent methodologies that investors can easily understand. This can provide greater transparency and accountability than more opaque active investment strategies.
Of course, like any investment strategy, factor-based investing comes with risks and challenges, and it may not be suitable for all investors. However, for investors seeking to achieve specific investment goals, factor-based investing can be a powerful tool for improving returns and managing risk.
Should you adopt Factor-based investing?
Whether or not to adopt factor-based investing depends on various factors, including your investment goals, risk tolerance, and time horizon.
Suppose you are seeking higher returns and willing to accept higher risk. In that case, factor-based investing may be a suitable strategy for you. By targeting specific factors that have historically been associated with outperformance, factor-based investing can improve returns and provide diversification benefits.
But, it’s important to note that factor-based investing is not guaranteed to outperformance, and different factors may perform well in different market environments. Also, factor-based investing requires expertise and knowledge, which may not be suitable for all investors.
Overall, factor-based investing can be helpful for investors seeking higher returns and greater diversification. However, it’s essential to carefully evaluate the risks and benefits of this strategy before making any investment decisions.
Factor-based investing, also known as smart beta, is a relatively new and innovative approach to investing that offers investors the potential to achieve better returns and manage risk more effectively.
By targeting specific factors that drive returns, such as value, momentum, or volatility, factor-based investing can provide a more targeted and systematic approach than traditional index-based strategies.
1. What are the main factors used in Factor-based investing?
The main factors in factor-based investing include value, momentum, quality, volatility, and size.
Value factors target stocks that are deemed undervalued by the market. In contrast, momentum factors seek to identify stocks with strong price momentum.
Quality factors focus on companies with strong financial fundamentals. In contrast, low volatility factors target stocks that historically exhibit lower levels of risk.
On the other hand, size factors seek to identify stocks of companies with smaller market capitalizations.
2. Is Factor-based investing a low-risk investment strategy?
Factor-based investing is not necessarily a low-risk investment strategy. While certain factors may provide lower volatility, other factors may be associated with higher levels of risk.
Like any investment strategy, factor-based investing is subject to market and other risks specific to the targeted underlying factors.
3. How does Factor-based investing differ from traditional investing?
Factor-based investing differs from traditional investing in that it seeks to identify and target specific factors or characteristics that are believed to drive returns rather than simply tracking a market index. This can lead to a more targeted and systematic approach to investing, potentially achieving better returns and managing risk more effectively.
However, factor-based investing requires expertise and knowledge and may not be suitable for all investors.