What is factor based investing?
Factor Investing helps investors to discover what ‘factors’ involved that explains the difference in stock market returns. Factor Investing is transforming the way investors construct and manage portfolios. It is an investment approach that involves targeting specific drivers of a 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. Macroeconomic factors capture broad risks across asset classes. Style factors attempt to explain returns and risks within asset classes.
Factors have historically been identified as critical drivers of portfolio risk and return and can now be used to better inform the investment process. Factors may help investors meet their objectives such as reducing risk, increasing returns, and increasing diversification by providing a better understanding of risk and returns.
Investment portfolios can be constructed and diversified based on the DNA that is hidden inside the stocks, instead of the stocks themselves. And, here is where the factor trading strategies are useful.
The only drawback of factor trading is that there are hundreds of factors that can affect the value of your investment. This can sometimes make factor trading rather complicated.
Some of the critical factors are as follows
Size – meaning small-cap stocks tends to outperform over the long term.
Momentum stocks – stocks that are performing well in the short-term.
Quality stocks – high-quality stocks outperform low-quality stocks in the long run
The growing interest in factor-based investing is not just a temporary trend. Although factor trading has become popular only in the last 10 years, it will continue to work for two primary reasons:
Academic research that endorses the profitability of factor trading strategies.
More empirical data is put into practice.
A multi-factor portfolio allocation will continue to generate positive performance in the future as long as the construction of the portfolio is based on reliable factors.
Factor investing remains a superior way of investment strategy that will continue to work.
Bottom line is, factor investing is expected to deliver higher returns, but not without assuming a higher risk.