What is 'Factor Investing'

Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors; macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes. Some common macroeconomic factors include credit, inflation, and liquidity whereas style factors embrace style, value, and momentum, just to name a few. 

BREAKING DOWN 'Factor Investing'

Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk. Portfolio diversification has long been a popular safety tactic, but the gains of diversification are lost if the chosen securities move in lockstep with the broader market. For example, an investor may choose a mixture of stocks and bonds that all decline in value when certain market conditions arise. The good news is factor investing can offset potential risks by targeting broad, persistent, and long recognized drivers of returns.

Since traditional portfolio allocations, like 60% stocks and 40% bonds, are relatively easy to implement, factor investing can seem overwhelming given the number of factors to choose from. Rather than look at complex attributes, such as momentum, beginners to factor investing can focus on simpler elements, such as style (growth vs. value), size (large cap vs. small cap), and risk (beta). These attributes are readily available for most securities, and listed on popular stock research websites.

Foundations of Factor Investing

  • Value: Value aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow. 
  • Size: Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.
  • Momentum: Stocks that have outperformed in the past tend to exhibit strong returns going forward. A momentum strategy is grounded in relative returns from three months to a one-year time frame.
  • Quality: Quality is defined by low debt, stable earnings, consistent asset growth, and strong corporate governance. Investors can identify quality stocks by using common financial metrics like return to equity, debt to equity and earnings variability. 
  • Volatility: Empirical research suggests that stocks with low volatility earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one- to three-year time frame is a common method of capturing beta.
RELATED TERMS
  1. Small Minus Big - SMB

    Small Minus Big (SMB) is one of three factors in the Fama/French ...
  2. Barra Risk Factor Analysis

    The Barra Risk Factor Analysis is a multi-factor model, created ...
  3. Style Analysis

    Style analysis is the process of determining what type of investment ...
  4. Portfolio Management

    Portfolio Management involves deciding investment mix and policy, ...
  5. Factor

    A factor is a financial intermediary that purchases receivables ...
  6. Fama and French Three Factor Model

    The Fama and French Three-Factor model expanded the CAPM to include ...
Related Articles
  1. Financial Advisor

    How to Factor in Smart Beta for Client Portfolios

    Smart beta ETFs based on factors can be a tool for advisors and individual investors to diversify.
  2. Investing

    6 Risks Threatening Your Portfolio Today

    Factoring in these risks is crucial when building a portfolio.
  3. Investing

    How to Use a Benchmark to Evaluate a Portfolio

    What is an investment benchmark and how is it used to evaluate the risk and return in a portfolio.
  4. Investing

    How to Diversify With a Style-Based Approach

    Investors who want a truly diversified portfolio should also consider diversifying by style.
  5. Investing

    Diversify Your Strategies, Not Your Assets

    Find out how to achieve true portfolio diversification where the benefits are real and pro­vide tangible results. Learn how to identify return drivers.
  6. Investing

    How to Pick Your Investments

    Understanding the basics doesn’t take long. However, mastering the nuance of every available investment could take a lifetime.
  7. Investing

    Build A Model Portfolio With Style Investing

    This sophisticated approach will add flair to your returns.
  8. Investing

    A Surprising Factor Leads Smart Beta Flows

    The value factor is lagging, but it is offering value and investors remain interested in value stocks.
  9. Investing

    A Fund's Investment Objective

    Learn to evaluate a fund's investment objective, or "style".
RELATED FAQS
  1. What percentage of a diversified portfolio should large cap stocks comprise?

    Learn more about achieving optimal diversification of an investment portfolio, and specifically about the percentage of large-cap ... Read Answer >>
  2. Use market risk premium for expected market return

    Find out how the expected market return rate is determined when calculating market risk premium – and how to estimate investment ... Read Answer >>
Hot Definitions
  1. Current Assets

    Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
  2. Volatility

    Volatility measures how much the price of a security, derivative, or index fluctuates.
  3. Money Market

    The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
  4. Cost of Debt

    Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.
  5. Depreciation

    Depreciation is an accounting method of allocating the cost of a tangible asset over its useful life and is used to account ...
  6. Ratio Analysis

    A ratio analysis is a quantitative analysis of information contained in a company’s financial statements.
Trading Center