What Is Factor Investing?

Factor investing is an investment approach that selects securities based on factors historically linked with high returns and lowered risk. In particular, factor investing provides a targeted method to enhance diversification and mitigate losses due to asset correlation.

🤔 Understanding factor investing

Think of factor investing like a filter for potential securities. You start by selecting a factor, such as low volatility, value, or momentum. Then, you pour prospective investments in – and see what filters into your portfolio.

In this way, factor investing allows investors to either streamline their portfolios toward specific outcomes or target broader – but still well-defined – goals.

For instance, if you’re saving for retirement, a broad-strokes strategy might seek increased dividends and low volatility. On the other hand, an investor looking to make a down payment on a house in 10 years may try to beat the S&P 500’s performance by 15% annually.

Regardless of the specifics of your desired outcome, the overarching goals of factor investing often remain the same:

• Outperform the broader market
• Enhance or contribute to diversification strategies
• Control or reduce risks
• Lower overall portfolio costs

The “factors” of investing

There are literally hundreds of factors you can consider in building a factor investing strategy. Here are just a few.

• A value approach aims to capture returns from undervalued stocks. Typically, you measure value by tracking dividends, free cash flow, and the price-to-book or price-to-earnings ratios.
• Momentum approaches filter out those securities that outperform the market in the past three to twelve months – while tossing the underperformers by the wayside. 
• Weeding out companies by size helps you determine which stocks have greater growth potential according to a company’s market capitalization. (Hint: small-cap stocks have more room to increase returns.) However, smaller companies generate higher returns at the expense of higher risk.
• Low volatility securities tend to yield greater risk-adjusted returns than high-volatility assets (though, admittedly, they’re less exciting). One of the most common ways to capture beta (estimate risk) is by measuring the standard deviation over the past one to three years.
• Quality is assessed by common financial metrics such as debt-to-equity, earnings viability, and return-to-equity. Simply put, companies that generate superior profits, maintain low debt, and demonstrate strong corporate governance often prove more consistent in the long-term.

An investor may adopt any or all of these as a viable investment strategy. In factor, the best-performing portfolios (in the long-term) often take a multi-factor approach to account for (and profit from) cyclical economic performance. A multi-factor approach can also neutralize risk, further enhance diversification, minimize correlation, and increase profit potential.

What this means for you

Beginning factor investors who find themselves flustered by the sheer number of options may decide to opt for a rules-based ETF or actively managed fund that follows factor investment strategies, such as the:

• iShares MSCI USA Min Vol Factor ETF
• iShares MSCI USA Value Factor ETF
• iShares MSCI USA Momentum Factor ETF

Alternatively, investors who do their due diligence may enjoy building a portfolio based on any number of factors or multi-factored approaches. If this sounds like you, it may be best to start small, with fewer and simpler elements at first, such as growth, size, risk, and returns. Over time, as you grow comfortable with your risk and abilities, you may add or revise your factors as you see fit.