What is Factor Investing?
Factor investing systematically targets specific characteristics, or factors, that academic research has linked to higher risk-adjusted returns over long periods. The most widely recognized factors include value (cheap stocks outperform expensive ones), momentum (recent winners continue winning), size (small caps outperform large caps), quality (profitable firms outperform unprofitable ones), and low volatility (less volatile stocks deliver better risk-adjusted returns).
Implementing Factor Strategies
Smart beta ETFs and factor funds provide accessible exposure to individual factors or multi-factor combinations. A multi-factor approach that blends value, momentum, and quality has historically delivered 1-3% annual excess returns over market-cap-weighted indices. Factor tilts can be applied across equities, fixed income, and even currencies.
Key Considerations
Individual factors can underperform for extended periods. The value factor, for instance, lagged growth stocks for over a decade from 2010 to 2020. Factor crowding, where too many investors pursue the same factor, can diminish future returns. Diversifying across multiple factors helps smooth performance cycles.