Factor Investing - What's different about this way of investing?

Date : September 18,2023

Investing is an art as much as it is a science. It requires a keen understanding of the financial markets, ability to analyse and process multiple data and news, and an unquenchable thirst for knowledge. In recent years, there has been a significant shift in the investment landscape, with a new paradigm taking centre stage - Factor Investing. This innovative approach to investment management has been gaining traction amongst savvy investors, offering an intriguing alternative to the traditional methods of investing.

What is Factor Investing?

Factor investing is a strategy that involves selecting securities based on attributes that are associated with higher returns. These characteristics, or "factors," include elements such as value, size, momentum, quality, and volatility, among others. By strategically incorporating these factors into an investment portfolio, investors can potentially enhance returns, reduce risk, and improve diversification.

Factor investing's roots go back to the 1960s when economists began exploring what drives the returns of a portfolio. They uncovered certain common characteristics (factors) that could explain the differences in returns of different securities. Since then, the field has expanded and evolved, with research consistently revealing new factors that can potentially enhance investment outcomes.

The Difference: Factor Investing Vs Traditional Investing

Traditional investment strategies typically revolve around asset allocation - dividing investment money among different asset classes such as stocks, bonds, and cash. Within each asset class, securities are selected based on analysis or simply market capitalization.

Factor investing, on the other hand, transcends asset classes and geographic boundaries. It looks beneath the surface to identify the fundamental, economic drivers of returns. The factors are broad, persistent characteristics that have historically driven returns. For example, the 'value' factor refers to investing in stocks that are cheap or undervalued compared to their intrinsic value.

The core difference lies in the approach to diversification. Traditional investing achieves diversification by spreading investments across different asset classes. Factor investing provides diversification across different factors, thus providing a multi-dimensional perspective to diversification. Each factor has a distinct and different economic rationale for its risk and returns which have low correlation to each other. This provides the benefit of diversification.

Why is Factor Investing Gaining Popularity?

The increasing popularity of factor investing can be attributed to several reasons:

Enhanced Returns: Research has shown that factor investing can potentially generate superior returns over the long run. The 'value' factor, for instance, has demonstrated a propensity to outperform the market over long investment horizons.
Risk Management: Factor investing allows for better risk control as it uncovers risks that are not apparent in traditional investing. For example, a portfolio might appear diversified in a traditional sense (across industries or geographies) but could be heavily tilted towards a single factor such as 'size'. Uncovering this can help investors manage their risk more effectively.
Transparency: Factor investing provides a clear, systematic approach to investment. Investors can understand what drives their portfolio returns and make informed decisions accordingly.

Challenges in Factor Investing

Like any investment strategy, factor investing is not without its challenges. Timing factor investments is difficult, and factors may underperform for extended periods. Also, identifying factors that will deliver premium returns in the future is not a straightforward task. It requires substantial research and a deep understanding of financial markets.

Furthermore, while factor investing reduces some risks, it introduces others. For instance, factor investing may lead to concentrated sector exposures. Therefore, it's crucial for investors to understand these risks before adopting a factor investing strategy.

Conclusion

Factor investing represents a shift in the investment paradigm, offering a new lens to view and navigate the complex financial markets.

Factor investing is a method of investing that involves targeting specific drivers of return across asset classes. These drivers, known as factors, are broad, persistent, and long-term performance drivers such as value, momentum, quality, size, and minimum volatility. Despite these being long-term drivers of returns, it doesn't stop investors from adjusting their factor portfolios in the short run, continually evolving the way factors are implemented.

Over the past few years, factor investing has evolved significantly. Originally, portfolios began with an index core and then used deep factor exposures to align the portfolio with the amount of risk the client was willing to take. Then portfolios were developed that were purely factor-based with high and low factor exposures, but the use of index funds to capture market beta was largely forfeited. Recently, many advisor portfolios are reverting back to creating a core portfolio with factors used as instruments to either express a view of where we are in the economic cycle, or to create a long-term exposure to factors like small size, value, quality, or momentum.