Factor investing is an investment strategy where investors choose securities based on the factors or attributes that are generally associated with higher dividends. The primary aspect of factor investing is that investors move into a far more molecular level when it comes to attributes that result in more profit, factors like style, size, risk, etc.
Of course, portfolio diversification has been a pretty safe method of investment to spread the risk over all asset classes. But, what if the chosen securities react in the same way to a certain market condition? An investor might choose a mixture of different stocks and bonds that all decline due to a certain condition in the stock market. Factor investing will take a look at the specific attributes of stocks and will help determine beforehand whether they will move in a similar direction.
Traditional allocation of stocks and bonds are fairly easy to implement in a portfolio to make it diversified. This makes the entire process of factor investing pretty complicated. But you should rather focus on the simple attributes like growth vs. value, large cap vs. small cap and risk rather than focusing on complicated attributes like momentum.
These attributes or the factors are nothing but a broad driver of dividends that have been proved to add more value to your already diversified portfolio for better returns and lesser risk. With the advancement in technology today, it has been easier to determine these factors for investors. Along with that some misconceptions and confusing ideas have come up as well.
Here are three things that you should know about Factor Investing:
Factor Investing is not Only for Stocks
The most popular factor strategies that are adopted by investors revolve around momentum, value, quality and minimum volatility. However, you should note that these concepts are not limited to stocks only. These concepts and strategies can be used for other asset classes as well like bonds, commodities, currency, etc. For example, if we consider a lesser known factor such as fixed income we will see that this factor too tries to take advantage of the shortcomings of the stock market. This is largely driven by two macroeconomic risk attributes, interest rate risk and credit risk. This strategy will help you improve your returns by balancing your risk.
Factor Investing is Necessary in any Portfolio
You might consider your portfolio diversified, but often it is not so. You may believe that since you are holding different securities, your portfolio will not be affected equally because you have spread your risk across different asset classes. But some securities might be affected by the same risks. If we take growth risk as an example, we will notice that if economic growth slumps, regardless of your diversification, a portfolio that is overly exposed to that particular factor will exhibit lower returns as a result despite being diversified. So, factor analysis is indeed necessary and will help you look through the walls of asset classes. In turn, you will be able to truly diversify your portfolio without any hassles.
Factor Investing is both an Active and Passive Investment Strategy
Factor investing is a combination of passive and active investing. It allows you to retain the benefits of both passive and active investment strategies. So, if you want improved returns and reduced risk at the same time, factor investing seems to give you the best of both worlds by creating an amalgamation of traditional active and traditional passive.