Factor based investing

What Is Factor Based Investing?

Factor based investing is an investment strategy that targets specific characteristics or "factors" of securities that have historically been associated with persistent differences in investment returns. This approach falls under the broader umbrella of portfolio management, aiming to enhance returns or manage risk by systematically tilting a portfolio towards these identified factors. Instead of focusing solely on individual stock picking or broad market exposure, factor based investing seeks to capture specific risk premium components. Common factors include value, size, momentum, quality, and low volatility. Investors employ factor based investing to achieve more granular diversification and potentially improve risk-adjusted returns beyond traditional market exposure.

History and Origin

The conceptual roots of factor based investing trace back to the mid-20th century with early research into market anomalies. However, the modern framework gained significant traction following the work of economists Eugene Fama and Kenneth French. In 1992, they published a seminal paper that introduced the Fama-French three-factor model. This model expanded upon the traditional capital asset pricing model by proposing that differences in average stock returns could be explained not just by market risk, but also by exposure to size and value factors¹⁸. Eugene Fama, a Nobel laureate, laid foundational groundwork with his efficient-market hypothesis, which posited that it is difficult to consistently predict short-term asset price movements¹⁷. Their later research on factors provided a framework for why certain stocks and fund managers tended to outperform others, paving the way for the implementation of multifactor systematic investing¹⁶.

Key Takeaways

• Factor based investing systematically targets specific security characteristics, or "factors," to drive portfolio returns.
• Common factors include value, size, momentum, quality, and low volatility.
• The approach aims to capture long-term risk premiums associated with these factors.
• It offers a structured way to build portfolios, moving beyond traditional market-cap weighting.
• Factor based investing can be implemented through various vehicles, including exchange-traded funds (ETFs) and mutual funds.

Interpreting Factor Based Investing

Interpreting factor based investing involves understanding that each factor represents a distinct dimension of equity returns. For instance, the "value" factor suggests that undervalued stocks, often characterized by low price-to-book or price-to-earnings ratios, tend to outperform over long periods¹⁵. The "size" factor points to smaller companies potentially outperforming larger ones. Meanwhile, "momentum" implies that stocks with recent strong performance may continue to perform well in the short to medium term.

Investors apply factor based investing by analyzing a portfolio's exposure to these factors, rather than just its overall beta to the market. A portfolio with a high exposure to the value factor, for example, is expected to perform well when value stocks are in favor. Conversely, it may underperform when growth stocks lead the market. Understanding these exposures helps investors align their portfolios with specific return drivers and their own investment beliefs. This approach contrasts with traditional active management, where outperformance is often attributed solely to manager skill or alpha.

Hypothetical Example

Consider an investor, Sarah, who believes that companies with strong financial health and stable earnings (quality factor) tend to provide more consistent long-term returns, and that stocks with lower volatility (low volatility factor) can help manage risk during market downturns.

Sarah decides to implement a factor based investing strategy. Instead of picking individual stocks, she invests in two hypothetical exchange-traded funds (ETFs):

• Fund A (Quality Factor ETF): This fund holds companies selected based on metrics like high profitability, low debt, and stable earnings. Sarah allocates 60% of her equity investing portfolio to Fund A.
• Fund B (Low Volatility Factor ETF): This fund invests in stocks that have historically exhibited lower price fluctuations than the broader market. Sarah allocates 40% of her equity portfolio to Fund B.

If the market experiences a period of high uncertainty and increased market risk, Sarah's portfolio, with its deliberate tilt towards quality and low volatility, might exhibit greater stability and potentially stronger relative performance compared to a passively managed, market-cap-weighted index fund. This example illustrates how factor based investing allows investors to systematically target specific risk-return characteristics within their asset allocation framework.

Practical Applications

Factor based investing is widely applied in various areas of finance, from institutional portfolio construction to retail investment products. In institutional settings, large pension funds and endowments use factor-based strategies to precisely tailor their exposures to different sources of return and manage portfolio risks. This can involve constructing custom portfolios that overweight or underweight specific factors based on current market conditions or long-term return expectations.

For individual investors, the proliferation of factor-based ETFs and mutual funds has made this strategy highly accessible. These funds offer systematic exposure to factors like value, momentum, or quality, often at lower costs than traditional actively managed funds. Furthermore, the principles of factor based investing are increasingly influencing quantitative and systematic investment approaches, where algorithms are used to identify and exploit these characteristics¹⁴. The increasing influence of systematic flows and factor-based ETFs is even reshaping traditional fundamental analysis and stock picking, with some market commentators suggesting that understanding factors is becoming essential for investors seeking a competitive edge¹³.

Limitations and Criticisms

Despite its theoretical appeal and empirical support over long horizons, factor based investing is not without its limitations and criticisms. A significant challenge is the potential for prolonged periods of underperformance. All factors, like other risk assets, can experience extended stretches where they underperform the broader market, testing investor patience¹¹, ¹². For example, the value factor has faced periods of struggle, particularly in certain markets¹⁰. Research also indicates that the diversification benefits of factor investing might be overstated, as correlations between factors can increase during market downturns, potentially reducing their risk-reducing properties⁸, ⁹.

Another concern revolves around implementation costs. While factor-based strategies often aim for lower fees, the actual transaction costs associated with rebalancing factor portfolios can erode expected excess returns, especially for strategies with higher turnover⁷. Furthermore, the rapid growth in the number of "discovered" factors has led to concerns about data mining, where factors are identified through historical data but may not represent true, persistent risk premiums⁶. Investors must carefully assess whether a factor is robust and driven by economic rationale or merely a statistical anomaly.

Factor Based Investing vs. Smart Beta

Factor based investing and smart beta are closely related terms that are often used interchangeably, leading to some confusion. While there is significant overlap, a key distinction lies in their conceptual framing and primary objectives.

Factor based investing focuses on identifying and systematically exploiting specific, empirically observed characteristics (factors) that explain differences in long-term asset returns. The emphasis is on the drivers of return, such as value, size, momentum, or quality, often rooted in academic research that suggests these factors represent compensated risks or behavioral anomalies. The goal is to capture these specific risk premium components.

Smart beta, on the other hand, refers to alternative indexing strategies that break the traditional link between a security's price and its weight in a portfolio⁵. Instead of market capitalization weighting, smart beta strategies use rules-based approaches to select and weight securities based on criteria like fundamentals (e.g., earnings, dividends), risk characteristics (e.g., low volatility), or equally weighting. While many smart beta strategies implicitly or explicitly gain exposure to known factors, their primary aim is to improve upon the risk-adjusted returns of traditional market-cap-weighted indexes, often by reducing concentration risk or targeting specific investment objectives.

In essence, factor based investing is the theory and academic framework of identifying return drivers, while smart beta is a practical implementation method that often leverages these factor insights to create indices or funds with specific weighting schemes. A smart beta portfolio might be designed to capture the value factor, but not all smart beta strategies are purely factor-driven, and not all factor-based strategies are implemented via smart beta indexing. The CFA Institute highlights that while a smart beta portfolio may generate higher compounded annual growth rates, an "alpha + beta" portfolio can offer better risk-adjusted returns and diversification benefits⁴.

FAQs

What are the main types of factors in investing?

The most commonly cited factors in factor based investing include value (undervalued stocks), size (small-cap stocks), momentum (stocks with recent strong performance), quality (financially healthy companies), and low volatility (stocks with stable prices).

Is factor based investing a form of active or passive investing?

Factor based investing can be considered a blend. While it's systematic and rules-based, similar to passive investing and indexing, it involves making active decisions to tilt away from market-cap weighting to capture specific risk premiums. Therefore, it's often referred to as "active at the index level" or a form of quantitative investing.

Can factor based investing outperform the market?

Factor based investing aims to generate excess returns over traditional market-cap-weighted benchmarks by systematically exposing portfolios to factors that have historically been rewarded with risk premiums. While academic research suggests factors can deliver persistent excess returns over long periods, there is no guarantee of outperformance, and factors can experience significant periods of underperformance³.

How do investors gain exposure to factors?

Investors typically gain exposure to factor based investing through specialized mutual funds, exchange-traded funds (ETFs), or directly managed separate accounts. These products are designed to systematically screen and weight securities according to the desired factor characteristics.

What are the risks of factor based investing?

Risks include prolonged periods of underperformance of a chosen factor, higher transaction costs due to portfolio rebalancing, and the possibility that historically observed factor premiums may diminish or disappear in the future due to market efficiency or overcrowding². It's crucial for investors to understand that factor returns can be non-normally distributed, meaning large negative outliers may occur more frequently than expected¹.