August 31, 2022

Factor investing is a dynamic strategy that can supercharge your investment portfolio. It’s all about selecting securities based on specific attributes linked to higher returns. But what exactly is factor investing, and how can it benefit you? Let’s dive in. Unpacking Factor Investing At its core, factor investing aims to enhance diversification, generate returns that outperform the market, and manage risk. It’s a strategy that goes beyond traditional portfolio allocations, like the classic 60% stocks and 40% bonds mix. Instead, factor investing hones in on a variety of factors that have historically driven returns in the world of stocks, bonds, and other assets. What is Factor and Factor Analysis? Why is Factor Analysis Important? The Two Main Types of Factors Factor investing divides these factors into two main categories: Macroeconomic Factors: These factors capture broad risks across asset classes. Think of them as the big-picture drivers of returns. They include economic indicators like inflation rates, GDP growth, and unemployment rates Macroeconomic Factors: Explain risks across asset classes. Macro Factors Core Macro Secondary Macro Style Factors: In contrast, style factors explain returns and risks within asset classes. They include attributes like growth versus value stocks, market capitalization, and industry sector. Factor investing is a robust strategy that harnesses macroeconomic and style factors to build an investment strategy. Investors have identified various factors, including growth vs. value, market capitalization, credit rating, and stock price volatility, among others. These factors are the building blocks of factor investing, and they can significantly impact your portfolio’s performance. Style Factors: Explain risks and returns within asset classes. Style Factors Macro Styles Equity Styles What is a Smart Beta Strategy? One common application of factor investing is known as “smart beta.” Smart beta strategies leverage these factors to construct portfolios that aim to beat the market’s average return. They target market anomalies or risks that command higher risk premiums than the overall market. Smart Beta2 strategies Smart beta investing seeks to derive a return from risk premia in the market; smart beta factors tend to be well-known and easier to implement. For example, the “momentum” factor is well known and is based on the belief that stocks that have recently increased in price may continue to increase in price due to the bandwagon effect. Constructing Smart Beta Strategies What are the Foundations of Factor Investing? Now that we’ve laid the groundwork, let’s delve deeper into some of the core factors that power factor investing: Diversification and Factor Investing What are the examples of Factor Investing? The Fama-French 3-Factor Model Developed by economists Eugene Fama and Kenneth French, this model builds on the Capital Asset Pricing Model (CAPM). It incorporates three key factors: size of firms (SMB), book-to-market values (HML), and excess return on the market. In this model, SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that outperform the market. The Smart Beta Revolution Smart beta strategies, rooted in factor analysis methodologies, aim to capitalize on these factors by constructing alternative indices. For example, a smart beta exchange-traded fund (ETF) with a momentum bias tracks stocks reflecting high momentum. These strategies are implemented through proprietary indices, often referred to as “self-indexing.” Additional Factors While we’ve covered some common factors, there are numerous others believed to drive greater long-term returns. These factors tend to be relatively uncorrelated, making them valuable tools for smoothing returns and controlling volatility. Factor Investing’s Diversification Advantage Diversification has long been a cornerstone of portfolio management. However, traditional diversification across asset classes may not be as effective as once believed, as these classes often move in tandem during market fluctuations. Factor investing offers an alternative approach. By focusing on underlying factors that behave differently under various market conditions, it promotes true diversification by factors rather than by asset classes. A Historical Perspective Factor analysis methods have been in use for decades, with early research dating back to 1934 when the value factor was identified by Graham and Dodd in their paper, “Security Analysis.” Exploring Factor-Based Strategies Factor-based strategies can be implemented in various ways, including leveraging or short-selling funds or indices. Risk premia strategies, for instance, target absolute returns through long-short investments. Alpha overlay strategies diversify by targeting different underlying factors. What is Equity Factor Investing Equity factor investing is a systematic and strategic approach to evaluating companies. At its core, this investment strategy aims to identify companies that stand out based on specific factors and then rank them against their peers. The Essence of Equity Factor Investing At its heart, equity factor investing is about going beyond surface-level analysis when assessing companies. Instead of solely relying on traditional metrics like earnings or price-to-earnings ratios, factor investing delves deeper. It examines a range of factors that can influence a company’s performance. These factors can encompass a wide array of attributes, such as: The Ranking Process Equity factor investing involves a systematic process of assessing and ranking companies based on these factors. This process can help identify those companies that appear more attractive from an investment perspective. For example, if a company scores well across multiple factors, it may receive a higher ranking. Conversely, a company that lags in these areas might receive a lower rank. This ranking system provides investors with a clearer picture of which companies are potentially more promising within a given investment universe. Alpha Opportunity One of the key reasons investors turn to equity factor investing is the pursuit of alpha. Alpha represents the excess return generated by an investment compared to a benchmark index. In simple terms, it’s the measure of how much an investment has outperformed or underperformed expectations. When higher-ranked companies emerge from the factor analysis, they may signal an opportunity for alpha. In other words, investors believe these companies have the potential to outperform the broader market. Equity alpha strategies typically seek to generate an informational advantage by utilizing various datasets to help identify securities that are priced too low or too