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Learn about factor investing, what different types of factors there are such as momentum and quality, the pros and cons of factor investing, how to combine factors and implement them into your strategy, examples of ETFs that do this for you and what multifactor vs single factor investing is.
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Factor investing is a method of selecting companies based upon the specific factors they hold, which can be either positive or negative. Companies with negative factors will usually be avoided, and positive factors will be sought out. Factor investing can aid portfolio diversification, risk-management and returns.
Factors are stock characteristics that impact or indicate the potential return or risk of an investment. For example, company growth affects the price trajectory of a stock, while volatility affects the risk. By focusing on certain factors, investors and professional managers can fine-tune a portfolio to balance risk and reward, minimise volatility, or maximise returns.
There are multiple factors affecting an asset that should be considered in asset management. Investors can choose to avoid a factor or rely on it aggressively. Factor indices or ETFs also do this, giving investors exposure to a minimised or maximised selection of factors aligned with their own goals and risk tolerance.
The following are factors that affect the risk and return profile of individual assets or stocks. These are often referred to as style factors.
Volatility
The volatility and/or beta of a stock gives an indication of the level of risk in an investment. Low volatility tends to equal a lower stock beta. The iShares MSCI USA Min Vol Factor ETF is an example of a fund that includes only low-volatility stocks.
Yield
Dividend yields identify investments that have high dividend payments to shareholders. It typically focuses on stocks with higher-than-average dividend yield or regularly increasing dividends. The iShares Core High Dividend ETF focuses on this factor.
Quality
Quality encompasses several sub-factors, including a company’s debt/leverage, earnings stability, earnings variability, investment quality and profitability. The iShares MSCI Intl Quality Factor ETF selects international stocks based on these criteria.
Momentum
Price momentum, i.e. stocks that are rising and/or accelerating to the upside on different time frames, is the focus of this factor. The iShares MSCI Intl Momentum Factor ETF places a high priority on momentum in global stocks.
Value
Value considers metrics such as price/book, earnings yield, and price/earnings when assessing whether a company is good value or not. The iShares MSCI Intl Value Factor ETF selects stocks based on metrics like these. Value investing is a popular investment strategy related to this factor.
Size
Size as a metric considers how large or small a company is and how that may affect performance. Size is broken down by market capitalisation (micro, small, mid, large, and mega). The iShares MSCI USA Small-Cap Multifactor ETF focuses on small caps but is multifactor and thus also includes other factors, such as value, quality, and momentum.
Growth
How much a company grows over time and how that affects its performance is another factor that investors consider. Earnings and sales growth are key metrics in this category. The Vanguard Growth ETF is an example of an ETF focused on growth stocks.
Liquidity
Liquidity looks at how much trading volume a stock typically has. Most ETFs and funds use liquidity as a factor, although it may not be directly stated. Most investors and fund managers prefer assets with enough volume to enter and exit with ease. Therefore, an asset that meets this condition is a typical requirement.
There are also wider macroeconomic factors that affect most assets on a larger scale. For example, a stock may look to be of great value, but if economic conditions are weak, that stock may not perform well until the economic conditions improve. These may be considered in addition to the style factors, but economic factors are not typically used for making investment decisions in isolation.
Economic growth
Economic growth is how a country is performing in terms of whether the economy is growing or shrinking. This is measured in terms of GDP, for example.
Interest rates/inflation
Interest rates and inflation affect stock prices. Therefore, an outlook for these factors may be included in stock analysis and portfolio construction.
Economic climate
The economic climate is the stability of the political situation in both domestic and international markets. War and instability affect how people spend money and invest, and the economic climate is, therefore, a factor that affects stocks and other assets on a wide scale.
Credit/financial
Credit and financial includes the financial health and lending risks within a country. This includes government default risk or high leverage and default risk across prominent sectors in the economy.
Factor investors typically utilise multiple stocks and ETFs, which provides diversification.
Diversification helps to reduce risk in a portfolio since no single stock can have a significant negative effect on a whole portfolio.
Only stocks that match the positive return traits associated with a factor are selected. This may help to bolster returns since stock selection is based on historically tested parameters.
Investors can customise what factors they want to focus on, allowing them to select the return/risk profile they wish to have in the portfolio and investment strategy. For example, they could target low volatility or aim for high returns with less regard for volatility.
In chasing one or two factors, investors may inadvertently hurt performance or increase risk. For example, an investor who focuses on larger companies (size factor) is ignoring a whole section of the market of small- and mid-cap stocks. An investor focused on growth stocks, which are typically priced higher in terms of price/earnings (P/E), may be missing out on diversifying into stocks that are attractively priced and have lower P/Es.
Factors can help give an indication of what the risk/return of an investment might be but doesn’t guarantee it. How a stock acted in the past doesn’t mean it will act that way in the future. This means theoretical returns for factors may be overstated and risks understated.
Single-factor strategies place a primary focus on one factor, such as value or dividend yield. Multifactor strategies attempt to focus on multiple factors at one time. For example, a multifactor strategy might involve finding value stocks that are also experiencing earnings growth or large-cap stocks (size) that are experiencing both growth in terms of earnings and yearly dividends.
Focusing on very specific criteria for the factors may seem favourable but can lead to tracking errors and diversification issues. For example, only buying deep value stocks with extremely low P/E ratios may look good on paper because some of these stocks will bounce back for big gains. But sometimes, these stocks never bounce back, leaving an investor with an undiversified portfolio. By only focusing on a single factor, the investor is highly reliant on that single factor for producing returns. With multiple factors producing investment exposure, the portfolio is more robust, striking a balance between risk and returns.
Multifactor strategies can also align with smart beta. Smart beta utilises passive investing combined with active trade management, and these trading decisions can be based on factors. Essentially, smart beta and multifactor try to combine the best elements from multiple factors and approaches.
A single-factor strategy or ETF could be combined to create a multifactor strategy. For example, an investor could allocate 5% of their portfolio to a dividend fund and 5% to a value fund. Or an investor could purchase a multifactor ETF that already combines several factors they are looking for, such as dividends and value. Including strategies that utilise more factors increases diversification.
Popular combinations include:
Small-cap and growth
Large-cap and growth
Large-cap and value
Quality and dividend yield or dividend growth
Quality and growth or value
Low volatility and quality
Quality and high momentum stock based on size
Investors can look for these qualities in individual stocks or can purchase ETFs that have these factors as their primary focus.
FAQs
There are factor ETFs that also require holdings to meet certain ESG standards. Investors could purchase a fund like this, such as the iShares ESG Aware MSCI USA ETF, or they could research stocks meeting the factors they desire and then only buy the ones that also meet their personal ESG criteria. Learn more about ethical and sustainable (ESG) investing.
Factor investing is a style of investing and asset management upon which strategies and portfolios are created. It is not a strategy in and of itself; it’s more a collection of tools. It is up to the individual to look at the performance history of factors (or factor ETFs) and decide how they wish to invest based on their own goals and risk tolerance. Read further about investing strategies.
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