At its core, factor investing is a form of personalized quality control. You have a set of criteria, or factors, that you believe are indicative of a stock’s success, and choose your investments by ranking companies based on these specific factors.
If you want to sound really in the know about this topic, then you can throw around the word “smart beta,” which is the jargony term for the factors that are meant to determine a stock’s performance. Factor investing is also no small niche among investors: since 2018, there’s been about $658 billion allocated to these so-called “smart-beta exchange-traded funds,” and it’s a popular way of navigating the stock market.
While factor-focused investors may look at a number of different factors when choosing what stocks to buy, there are usually two categories under which these factors fall under: macroeconomic and style factors. The former can include things like a company’s credit, inflation rates, and liquidity, while style factors can include things like a stock’s current momentum (or upward growth), it’s volatility on the market, and a company’s size and quality (its financial health). This differs from traditional index funds, such as the S&P 500, which sorts companies and their percentage of the index according to their size.
Advantages and disadvantages of factor investing
One of the most common reasons investors decide to engage in factor investing is because it’s designed to minimize risk by increasing a portfolio’s diversity, and if you’ve spent any time on this site at all you’ll know that diversification is the key to a successful long-term investment strategy. The reason why factors ensure a diversified portfolio is because the factors cover a wide variety of scenarios and are therefore more likely to perform well at different parts of the economic cycle. So if one factor is currently underperforming, there’s a good chance that another factor is doing well as a result.
Factors also minimize risk because they tend to encompass traits that have historically driven high and consistent returns. Since investors can isolate the traits that they’re most interested in pursuing, a smart beta strategy has the potential to maximize returns above market average. That’s why some investors choose a factor-investing strategy as a complement to their traditional index funds, since it helps mitigate exposure on the market and improve the likelihood that portfolios are well-covered during periods of volatility.
Minimized risk, a potential for high returns, portfolio diversification… So where’s the catch? Well, the thing with factor investing is that focusing exclusively on a smart beta strategy tends to be more expensive than investing in traditional index funds. As factor investing has grown in popularity, assets with desirable factor have often been pushed up in price, which also means that future returns are likely to be lower.
Another problem with this kind of investment strategy is that over-eager investors might miss the forest by focusing on all the trees. Or in this case, they might miss out on a well-balanced portfolio by focusing too much on a certain number of factors. A smart beta fund also potentially needs to be rebalanced more often, since a stock may not fulfill a certain factor anymore and may need to sold in order to be replaced with one that does.
And although factor investing does offer the chance to minimize risk because of focusing on certain factors, that strategy can backfire when a portfolio is too heavily dictated by certain smart betas. An investor can then actually expose themselves to more risks, may they be from overweighing the stock of smaller companies, reducing the number of stocks in a portfolio, or a combination of many risk factors. Since factor investing is usually active, not passive—meaning you’re actively participating in what stocks to buy and sell, when to do that, constantly monitoring a stock’s compliance with your chosen factors and making adjustments when necessary—, the chance of higher risks are even greater if the factors you’re focusing on emphasize above-average returns. The cardinal “high reward/high risk” stock market rule is as true here as it is everywhere else.
It should also be said that factor investing, like many other investment strategies, is definitely not a short-term strategy. Depending on what factors you focus on, your investments can go through periods of low performance. If you freak out and sell when your investments are down, you’ll be getting below-market rates and suffering losses that would have been significantly minimized if you’d ride out the lows.
Alternatives to factor investing
The thing about factor investing is that it’s often an attempt to beat the market by selecting the factors that you think will increase the likelihood of a stock’s above-average performance. That can get pretty expensive and stressful, because you have to be monitoring your investments, make necessary adjustments, and pay up for the additional costs that come from more frequent trading. These additional costs mean that factor investors might not actually beat the market’s current performance, even if they’re enjoying high returns.
If that sounds way too exhausting, then being a passive investor may be more to your liking. As a passive investor, you’re not trying to beat the market; you’re just trying to mirror the performance of the market instead. If that’s more what you’re interested in, then investing in traditional index ETFs may be a good alternative: they’ll help you build up a diversified portfolio without all of the stress of hand-picking stocks yourself.
An ETF is a bundle of fractional shares of individual stocks and bonds, and they’re a great way to diversify your portfolio. By having diversified investments, you ensure that you’ll be invested in enough sectors to be able to take advantage of positive trends without being wiped out by negative ones. With ETFs, you’re not just investing in stocks; you’re also investing in bonds, real estate, and other sectors, thereby spreading your money out and making more financially stable choices. Which brings us to our second point: low fees! Investing in ETFs is cheaper than picking stocks, because you don’t have to pay fund managers, make expensive trades, or respond to market fluctuations.
The whole thing gets even cheaper if you decide to trade with the help of a robo-advisor. A robo-advisor is an automated investment platform that uses an algorithm to create a personalized portfolio of ETFs for you, and is a solid option for those trying to get into the investing game but who are kept away by high fees and intimidating jargon. Another advantage? Robo advisors are accessible 24/7, no appointments necessary. And since the companies operate entirely online, you can sign up to a robo advisor, deposit money, check your balance, withdraw money, etc., all from the comfort of your own home.
If you do think you might want to explore factor investing, then finding a trading platform with low fees and no commissions might be a good place to start. If that’s not where you’re at right now, you don’t have to miss out on investing. At Wealthsimple, we’ll work with you to create a low-fee, personalized diversified portfolio that’s designed to meet your financial goals. Sign up today.