You've probably heard of value investing, which involves buying stocks that appear cheap and are also expected to rise. But have you heard of factor investing? It's a relatively new methodology catching on quickly with investors who want to go beyond valuation alone. It seems like a new type of investing strategy is announced almost every day – from social impact investing to ESG (environmental, social, and governance) investing. However, despite the growing array of options, some strategies remain much more common than others. Factor investing is one such strategy that has gained momentum in recent years. Factor investing is a strategy aiming to capture individual market factors' price movements. These are broad asset classes, such as value, small-cap, or growth stocks. Investors look for companies with favorable factors to take advantage of these segments and invest in them directly or through ETFs.
Factor investing, also known as "factor investing" or "smart beta," is a type of equity investment strategy that focuses on identifying and investing in companies based on their market segment characteristics. For example, an investor might invest only in small-cap stocks to seek out potential bargains among smaller companies. While there are many different ways to factor invest, most strategies can be categorized into two broad types: quantitative and qualitative.
Quantitative factor investing relies on computer algorithms and statistical analysis to select companies based on certain factors. These factors are defined and tracked by a third-party index provider, such as S&P or MSCI. Many quantitative funds are focused on a single factor, such as value or momentum. The process of finding the best factors to invest in is called "factor selection." Factors are often calculated using a company's financial data, such as its price-to-earnings ratio (P/E), price-to-book ratio (P/B), growth rate, and company size. However, not all factors are directly related to the company's financial data. Some factors, such as the overall state of the economy, are hard to quantify. Other factors are more indirect, such as the impact of interest rates on a certain industry.
With qualitative factor investing, an investor pores over the financial statements and management strategies of each company to find the ones with the most promising growth factors. And because qualitative factors are more subjective, they can be harder to track. When selecting a company, an investor looks at a number of factors in order to determine if it is a good investment. Some of the most common factors include the following:
- Value - a stock's price relative to its intrinsic value
- Momentum - a stock's rate of change in value over time
- Size - the size of a company relative to its industry
- Quality - a stock's overall financial health
- Sector - a stock's exposure to a particular sector
- Cyclicality - a stock's sensitivity to economic cycles
When it comes to getting started with factor investing, the first step is to select the factors you will use to build your portfolio. Once you've done that, you're ready to move on to the next step, which is to decide which investments are best suited to each factor. For example, you can build a factor portfolio around the idea that rising interest rates will be good for stocks. In this case, you might want to focus on stocks poised to benefit from higher rates, like utilities or real estate investment trusts (REITs). Another example could be an equity portfolio that is sensitive to investor sentiment changes. In this case, you might want to focus on stocks in industries where sentiment tends to be more stable, like financials and healthcare. As you pick your factors, you can further define your strategy by selecting the best way to track those factors. There are many ways to invest in factors, including ETFs, mutual funds, and individual stocks. Factor ETFs are passively managed, low-cost funds that track specific indices.
Some factors, such as value and momentum, are not tracked by any existing ETFs. In these cases, investors can buy ETFs tracking broader market segments, such as large-cap stocks. Factor mutual funds are actively managed funds that track specific indices. They come in a wide variety of flavors, such as value, small-cap, growth, and emerging markets. Individual stocks can be used to factor in investing. Still, they are riskier because they are not passively managed and are subject to the whims of the market.
Factor investing has several benefits. Chief among them is the potential for higher returns. By focusing on specific factors, an investor can find investment opportunities in overlooked stocks with lower risk. Factor strategies have also proven to be resilient to market conditions. Value stocks have outperformed growth stocks during downturns, and momentum stocks have done well when the market is rising. The diversification of different factors can improve an investor's overall portfolio, as each strategy can potentially offset a decline in another segment. Factor investing can be applied to any investment strategy. The best way to implement it will depend on your risk tolerance and investment goals.
While factor investing sounds promising, there are a few caveats to consider. First, factor investing is not a panacea nor guaranteed to outperform. Factors will ebb and flow, and investors who rely on them will be subject to market volatility. Second, not all investments are liquid and can be traded easily. Some factor investors choose to invest in individual stocks and ETFs listed on less-than-liquid exchanges. While these can be great investments, they can be hard to sell in a pinch. Finally, factor investing is not a stand-alone strategy. Investors who use only one or two factors are missing out on a broader range of potential opportunities.
- Interest rates - As interest rates rise, the value of fixed-income investments falls. Conversely, as interest rates fall, these assets become more valuable. Suppose you're building a factor portfolio around rates. In that case, you may want to select assets expected to do well when interest rates are rising.
- Sentiment - As noted above, sentiment refers to how investors are feeling at any given time. Sentiment tends to be more cyclical, spiking when the market is strong and dropping as it weakens. Suppose you're building a factor portfolio around the sentiment. In that case, you may want to select assets expected to perform well during periods of pessimism in the market.
- Correlation to other factors - In some cases, you might want to look for investments that are negatively correlated to other factors. For example, suppose you're building a factor portfolio around rates and want to include a tech stock. In that case, you might want to make sure that tech stock is negatively correlated to rates.
As you can see, factor investing is a unique strategy that can help you earn outsized gains even as the overall market is experiencing a correction. These new strategies are catching on quickly, with investors looking for a more concrete way to build a portfolio. While it may seem confusing at first, it's well worth your time to dig in and learn more about factor investing. The best way to invest for the long term is to diversify your portfolio across a variety of assets, risk factors, and geographies. Factor investing is one way to do that, but it should be part of a broader investment strategy. Factor investing may sound appealing, but it's important to remember that it's not the only way to build a portfolio. Investors who approach their portfolios with a long-term perspective and a balanced, diversified approach are likely to achieve better results over time.