Factor investing may or may not be something that you’ve heard of. But it might actually make the most sense for a long-term investing strategy. In this article/guide, we’ll explore what factor investing is including what it entails, how it works, why it works, and more.
Let’s get into it.
What Is Factor Investing?
Firstly, what exactly is factor investing?
Believe it or not, you may have heard of factor investing distantly without hearing it called “factor investing.”
Factor investing is a method of managing an investment portfolio that follows several clearly defined factors whose data can be tracked, collected, and analysed.
Once identified and analysed, these factors drive the investor to allocate money in such a way that diversification is achieved while allowing for higher returns than benchmarks.
In other words, factor investing is a hybrid active/passive investment style that requires following certain factors. We’ll describe the specific factors in a bit.
Although this sounds somewhat different to traditional investing, there are in fact overlaps.
And it’s these overlaps with the traditional form that might even make factor investing most attractive to those investors who like to take a direct role in managing their portfolio.
Put differently, while factor investing was traditionally only really applicable to the institutional investor with deep pockets, the unprescented growth in financial data science has meant it’s now much more accessible to retail investors, too.
Finding a successful investment style is something that most people with careers in the finance sector spend most of their time trying to do.
Most retail investors also spend time trying to figure out how to protect their retirement nest eggs.
It’s all about finding out how to not lose while making money at the same time.
Now, while simple conceptually, there are literally countless methods for accomplishing this.
But Factor Investing can do particularly well since it often ends up taking a data-driven approach to asset allocation, thereby reducing human biases and emotions.
What Types of Factors Are There?
Okay, now that you understand what factor investing is, let’s think about the different types of ‘factors’.
Broadly speaking, there are broadly two types of factors including:
- macroeconomic factors, and
- style factors
Note that this is somewhat of a simplification, but it’s a pretty fair representation of core known factors.
Let’s now consider both types of factors individually.
Macroeconomic Factors
Macroeconomic factors focus on external drivers of asset prices that affect all asset classes, including stocks, bonds, real estate, commodities, etc.
In the context of Macroeconomic Factor Investing, the key idea is to create an investment strategy that sort of “rides” along with the macroeconomic events.
It’s about riding with the wave, if you will.
Common macroeconomic factors include (but aren’t limited to):
- inflation
- interest rates
- economic growth, and
- credit
Let’s now consider each of these individually.
Inflation
Inflation is generally a good thing indicating growth, but increased inflation could also be a ‘lag’ for slowdowns.
For instance, higher prices mean people may be less likely to buy things, and this might cause asset prices to go down.
An “inflation factor strategy” might be one that goes long in stocks up to and including the ‘switch’ to the slowdown.
Interest Rates
At the time of writing, we are in the midst of the lowest interest rates in history.
But that could be changing soon.
Rising interest rates can have a broad effect on market prices.
t creates higher operating costs for businesses, increase the discount rate (aka cost of capital), decreases their ability to churn out profits.
And it can also decrease consumer motivation to buy large purchases like houses or cars due to higher loan costs.
Economic Growth
This is generally represented as GDP growth for a particular country.
Higher GDP growth means higher growth each year, and vice versa.
Stock prices reflect investors’ beliefs about the future value of a company, and broad economic growth will generally lead to investors willing to believe companies will grow as well.
Credit
Companies take out credit just like you and I do, but they do so via bonds or other fixed income securities.
While credit markets are affected by many of the above factors, it’s important to be aware of default risk when lending to companies.
In each of these instances, the fundamental idea is to create a factor investing strategy that “goes with the wind” of the macroeconomic factor.
Note that macroeconomic factors tend to be systemic / systematic risk in that they cannot be controlled or influenced by any one individual.
But, for example, one might start going long in banks prior to an expected rise in interest rates to be able to profit from the bank’s greater profitability.
Yes, the ‘idea’ above is speculative. However, it can be validated before execution/implementation.
This is consistent with what we said earlier, about how factor investing takes a data-driven approach to asset allocation, and thereby reduces human biases and emotions.
Style Factors
Style factors are those which affect only certain assets. They’re not systemic so to speak.
These factors can allow focusing on specific stocks or other assets.
As the fundamentals of the stocks change, you may reallocate funds to other assets to maintain focus on these factors.
Popular ‘style’ factors include (but again, aren’t limited to):
- value
- momentum
- size, and
- ‘quality’ (note: this is not a generally accepted term)
Value
This is just one of the many factors, and it typically involves going long in high book-to-market stocks (i.e., value stocks) and shorting those with low book-to-market ratios.
Momentum
These stocks are almost the opposite of value stocks.
They are high-priced assets that could continue to increase in value depending on the expansion efforts.
Further growth is dependent on investors’ belief the company will continue to grow in addition to company fundamentals.
Size
While larger-sized companies may seem to be a draw due to their relative safety, those with a lower market capitalization (small-cap companies) tend to be the most eager to become mid-cap and then eventually, large-cap companies.
In other words, small-cap companies allow a greater potential return than large-cap firms given higher growth prospects.
Quality
This factor and the next one are included with safety in mind.
While companies with low debt and high return on assets may not show enormous growth, investing in such assets can help reduce volatility in your portfolio.
As with the macroeconomic factors, the fundamental idea of style factor investing is to ‘ride the expected wave’.
So, for example, let’s consider the Size factor (aka Size Premium).
A Size Factor Investing strategy would involve going long in small-cap stocks and shorting large-cap stocks.
Note that, although the Size Premium has been shown to hold, and is one of the most important factors in the Fama French 3 Factor Asset Pricing Model, the results tend to be somewhat mixed in practice.
For instance, consider the chart below which plots out the performance of the FTSE100 and the FTSE Small Cap indices.

While the FTSE Small Cap has performed approximately 2.5x times as well as the FTSE100 over the entire sample timeframe, it’s clear that there are instances where the FTSE100 outperforms the FTSE Small Cap.
In particular, notice the performance during the dot-com bubble (say, 1999 – 2002) and the Great Recession (2007 -2009).
The FTSE100 appears to perform somewhat better than the FTSE Small Cap in downturns / financial crises.
Of course, there’s nothing to say that you can’t “flip” the strategy!
In such an instance, you’d essentially short the small-cap stocks and go long in the large-cap ones.
Hopefully, you now have a good understanding of what factor investing is and what the different types of factors are.
We’ve touched on how factor investing works in practice already, but let’s now dive deeper.
How Does Factor Investing Work?
While it might seem like these are simple factors to understand, successful factor investing depends heavily on your ability to fine-tune the data.
It’s about “slicing and dicing” the data to try and identify anomalies or opportunities for alpha.
Like with the Size Premium example above, the theory and traditional data tell us to go long in small-cap stocks and short large-cap ones.
However, as the chart above shows, there are some instances where the reverse would be more optimal.
This approach can work for existing factors (e.g., Size, Value, Inflation, etc) by exploiting any given factor premiums.
But we can create our own factors, too!
Creating Factors for Investing
Factor investing involves focusing on one or several factors, and coming up with a way to put numbers on those factors, and finding assets that fit the strategy.
This might seem complicated, but it really boils down to asking the right questions.
For instance, how do you put a number on “value”? So how can it be calculated?
Well, the stock details posted by your investment firm or platform (assuming it’s a good one) will include things like price-to-book, price-to-earnings, dividends, and free cash flow.
You can come up with a method of calculating “value” based on these and other posted numbers.
Traditionally, however, “value” would be measured in terms of book-to-market (the inverse of market-to-book or price-to-book).
In our Data Driven Investing course, we created an “ESG Factor” from scratch.
Essentially, we apply factor investing strategies in the context of ESG Investing in that particular course.
We can’t quite disclose what we found because, well, spoilers!
But in terms of the approach, the idea’s to identify some sort of characteristic or attribute of firms (if you’re using a ‘style factor’ for example).
And then use that to “sort the sample” or “sort portfolios” based on varying degrees of the characteristic of interest.
These essentially become your individual factor portfolios.
For instance, you might look at firms with “higher ESG risk” and compare them to those with “lower ESG risk”.
It would then be a case of shorting one group and going long in the other to create an “ESG Risk Factor”.
Okay, so you now know what factor investing is and how it works.
But why does it work? Let’s find out.
Why Does Factor Investing Work?
Over the last few decades, several prominent economists, including Nobel Prize winners, have published their research showing that returns are driven by certain factors.
The reasons they were published and won prizes is that they were able to define exactly what those factors were.
It’s fairly well known that investors aren’t rational 100% of the time. This includes professional investors, too.
True Asset Pricing folks will likely disagree with this, but it is true, really.
And human biases can prevent optimal performance when it comes to investments.
Factors are good for identifying non-biased information and finding the assets that can grow, regardless of short-term investor biases.
Market impediments are also well-known to affect asset prices, hence a whole section devoted to macroeconomic factors.
Lastly, factor investing works by helping to quantify the willingness of investors to take on more risk.
For example, combining factors from both the macroeconomic and the style categories can help show whether investors might continue to invest in riskier assets or move into safer ones.
What Benefits Do I Get With Factor Investing?
Factor investing brings many benefits. Perhaps the top three would include:
- Diversification – using data across multiple sectors and asset classes allows for truly wide diversification
- Higher potential returns – By reducing dependency on short-term investor bias and focusing on quantifiable data, you can find better value than investing subjectively.
- Reduced risk – There is risk to all investing, but increased diversification also leads to reduced risk, generally speaking, thanks to relatively low volatility.
What Drawbacks Are There With Factor Investing?
Just as there’s no such thing as a “free lunch”, so too, there’s no such thing as benefits without drawbacks.
It’s fair to say that the three biggest drawbacks of factor investing include:
- Research requirements – A well-developed factor investing strategy requires research not only about the assets you’d like to invest in but also about how the market works and the best data to include in your strategy.
- More time and management than fully passive investing – Unless you implement some sort of algorithmic trading, you’ll need to manage your portfolio when you see assets falling outside your parameters. You don’t need a complicated strategy, but prices change all the time, so scheduled management intervals might be necessary
- Increased risk – You might wonder why we’ve put the opposite bullet point here. That’s because a poorly developed strategy can lead to lower returns than the benchmark / market portfolio, or even losses of capital.
Final Thoughts: Factor Investing
Factor investing can be hugely rewarding for those investors with an interest in actively managing a portfolio.
The factors have been defined by some of the best minds in economics. But they require some thought before diving into the markets.
However, the potential to achieve higher returns through factor based investing is very real, especially for a well-researched factor based strategy.
If you’d like to learn more about factor investing, including creating your own factors…
Then you should definitely check out our Data Driven Investing Course.
Leave a Reply
You must be logged in to post a comment.