What Are Factors?
The type or blend of factors deployed by investors depends largely on their risk tolerance and underlying objectives. Factor-based strategies have been known to help investors improve returns and lower risk over long-term horizons. This is true of single-factor strategies as well as those seeking exposure to multiple factors at the same time.
Portfolios gain exposure to factors through a combination of historical analysis, selection, weighting and rebalancing in favor of assets that meet certain characteristics, such as enhanced risk-adjusted returns or low volatility. In practice, investors can gain exposure to factors through quantitative, actively-managed funds.
Learn here about choosing the right commodity mutual fund.
Types of Factor Investing
Macroeconomic factors capture broad risks across asset classes. They include things like economic growth, interest rates, inflation and emerging markets.
Style factors are used to help explain returns and risks with specific asset classes. Things like value, momentum, minimum volatility, quality and size are all examples of style factors.
While there are several actively-managed mutual funds that offer factor investing, exchange-traded funds (ETFs) are the vehicle of choice for most investors. This holds true despite the fact that some mutual funds offer higher factor exposure than smart-beta ETFs. There could be many reasons why investors prefer ETFs over mutual funds, but the most likely explanation is the relative underperformance of factor-based mutual funds compared to their ETF counterparts. Higher fees are another reason why ETFs are more popular.
That being said, factor investing through mutual funds is still a worthwhile endeavor, depending on your investment goals. The Vanguard U.S. Multifactor Fund Admiral Shares (VFMFX) and the Global Minimum Volatility Fund Admiral Shares (VMNVX) are two prominent examples.
Below is an illustration of so-called systemic factors, which form the basis of most factor-based strategies. As you can see, most of these fall under the umbrella of style factors.
|Factors||Description||Measured By||ETF Examples|
|Value||Assets with a low price relative to their fundamental value.||Book to price, earnings to price, earnings, net profit, dividends, revenue||iShares Edge MSCI USA Value Factor ETF (VLUE), iShares Edge MSCI Intl Value Factor ETF (IVLU)|
|Low Size (Small Caps)||Excess returns of smaller companies relative to their larger counterparts.||Market cap||iShares Edge MSCI Multifactor USA Small-Cap ETF (SMLF)|
|Momentum||Assets with stronger past performance.||Relative returns, historical alpha||iShares Edge MSCI USA Momentum Factor ETF (MTUM), Invesco DWA Momentum ETF (PDP)|
|Low Volatility||Assets with lower than average volatility, beta.||Standard deviation, beta||iShares Edge MSCI Mini Vol USA ETF (USMV), JPMorgan Minimum Volatility ETF (JMIN)|
|Dividend Yield||Assets with higher than average dividend yields.||Dividend yield||Schwab US Dividend Equity ETF (SCHD), Vanguard Dividend Appreciation (VIG)|
|Quality||Assets with low debt, stable earnings and growth.||ROE, earnings stability, dividend growth, balance sheet strength, management strength||iShares Edge MSCI USA Quality Factor ETF (QUAL), Vanguard US Quality Factor ETF (VFQY)|
Benefits and Drawbacks of Factor Investing
During the height of the bull market in 2017-18, every factor except value was outperforming the market. However, factors such as momentum are hit-and-miss. Momentum was the best-performing factor in 2017, but it has offered no aggregate value over the previous ten years because of the financial crisis in 2008-09. As such, factor investing can be highly cyclical and prone to fluctuations. Additionally, research from Robecco Institutional Asset Management found excess returns for low-beta, value and small-cap funds but no consistent returns for momentum and reversal funds.
In terms of other advantages, many factor-based strategies provide exposure to multiple factors within one vehicle, which gives investors a better shot at achieving their desired outcomes. Additionally, factor-based models represent a broad universe, which means diversification across many asset classes and factors is possible. Finally, advances in technology and data analysis allow investors to take advantage of factor-based models using more enhanced tools and processes.
On the opposite side of the spectrum, factor investing has a few notable drawbacks. For starters, no single factor works all the time. In fact, returns tend to be cyclical, which means extended periods of underperformance are possible and even likely. What’s more, the market for factor-based strategies has become more crowded in recent years, making it more difficult to pick out funds that will produce the desired results. Poorly constructed strategies can actually give you unintended exposures to factors you did not target initially. And because these strategies are actively managed, you can expect to pay more in terms of management fees.
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The Bottom Line
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