Factor Based Investing

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What is factor investing?

Factor investing is an investment approach that involves targeting specific drivers of return across asset classes. There are two main types of factors: macroeconomic and style. Investing in factors can help improve portfolio outcomes, reduce volatility and enhance diversification.

Why invest in factors?

Institutional investors and active managers have been using factors to manage portfolios for decades. Today, data and technology have democratized factor investing to give all investors access to these historically persistent drivers of return.

What’s the difference between factor investing vs smart beta?

Smart beta is one subset of factor investing. Factor investing harnesses the power of broad and persistent drivers of return. Factor investing can refer to macro factors (which affect returns across asset classes) as well as style factors (which affect returns within asset classes) and can be implemented with or without leverage. Smart beta strategies generally refer to style factors within a single asset class, implemented without leverage, most commonly in style factor strategies that are long only and index based, most commonly in an ETF.

There is a significant difference between smart beta and factor investing in portfolio construction. … Smart beta ETFs have stock market correlations greater than 0.9. By contrast, a long–short multi-factor portfolio has zero correlation with beta.

What are the risks associated with factor investing?

When it comes to factor-based strategies, investors have a lot of options. Each strategy is constructed in a unique way and may have different risks. It’s important that investors understand underlying exposures in the context of the outcome you wish to achieve. Investors who choose long-short factor strategies will add risks associated with leverage.

What are some of the myths associated with factor-based investing?

One of the most pervasive myths around factor investing is that it must be used instead of indexed or active investments. Factor-based strategies, including Factor ETFs, can be used both to replace and to complement traditional index or active investments in the portfolio.

Important consideration

As with any investment, there’s no guarantee of performance. Individual factors have tended to perform well at different parts of the economic cycle, and may be less correlated with equity market moves. Be aware of this aspect of factor investing as you investigate whether any particular strategy makes sense with your investment goals. A multi-factor investment is diversified across factors and may help to reduce the effect of this cyclicality.