For decades, the hallmark of a solid investment plan has been portfolio diversification: a relatively simple concept that equates to not “putting all your eggs in one basket.” By incorporating a healthy mix of investments across a range of asset classes, sectors, and geographies, investors can theoretically minimize the likelihood of concentrated losses in one area.
While this conventional wisdom still carries weight, the market realities of the 21st century have challenged many existing assumptions about diversification. The negative correlation between asset classes such as bonds and equities was once considered a mainstay of portfolio construction, but is increasingly considered under threat. A longer-term shift in this relationship, meaning that bonds and stocks fall in lockstep, could make it increasingly difficult for investors to create low-risk portfolios.
These changing dynamics are among the developments that have accelerated broader adoption of factor investing, an approach that can help investors make sense of shifting market conditions and mitigate risk in their portfolios.
What is factor investing?
Factor investing rests on the premise that there are various attributes, or factors, underpinning the performance of each investment. These are well-studied, quantifiable and measurable characteristics that have demonstrated a reliable correlation with returns over time. By targeting exposure to these factors in their portfolio, investors may benefit from enhanced diversification and potentially higher returns.
Think of it like a car. All passenger automobiles on the market comprise a number of essential components, such as the engine, battery, tires and chassis. However, the owner might decide to implement tweaks or modifications to these components based on their specific needs. For example, they might purchase performance tires for acceleration or snow tires to maintain traction in challenging conditions. Others might consider a suspension upgrade to achieve more precise handling and braking.
Just as a car owner might target features that make their car better suited to their performance and safety needs, factor investing offers investors a more thoughtful, customizable approach to addressing their portfolio risk and return objectives. And because factors generally exhibit low correlations with one another, investors can use them to diversify a portfolio across different underlying characteristic risk factors.
What are the different types of factors?
Factors typically fall into two main categories: macroeconomic and style. Macroeconomic factors explain risks across multiple asset classes, and include concepts that are likely somewhat familiar to most investors—e.g. inflation, gross domestic product (GDP) growth, and interest rates.
Style factors, which are the most commonly implemented, can help investors to pinpoint drivers of risk and return within asset classes. They include:
- Value. We all like a good bargain. This factor relies on fundamental analysis to help investors identify and purchase quality companies whose attractive stock prices belie their promising fundamentals.
- Size. Bigger isn’t always better. Factor investors may target small-cap stocks that, though usually riskier investments than their large-cap counterparts, can offer significant growth potential to long-term investors.
- Quality. This reflects the overall durability of a company and is usually assessed using criteria such as debt levels, earnings and asset growth, leadership credibility, and accounting practices. Many of these same measures are important to sustainable investors, especially those focused on strong corporate governance.
- Momentum. Although the ubiquitous “past performance is no guarantee of future results” is entirely sage advice, momentum recognizes the tendency of stocks that have recently performed well to continue winning in the near term. Factor investors typically implement momentum by selecting stocks that have gained over the prior three to 12 months, usually ignoring the most recent month’s performance.
- Volatility. Research suggests that stocks with more stable return patterns are likely to outperform those with a history of sharp price swings. This factor is captured by looking at the standard deviation of price changes over a one- to three-year time frame.
Why factor investing?
To us, factor investing is a fairly intuitive proposition. After all, knowledge is power, and expanded access to financially material information can help investors make more educated decisions about what’s in their portfolio. This is an idea already familiar to many sustainable investors; in fact, we often hear environmental, social and governance (ESG) investing referred to as “full-information investing.” This is because it extends beyond traditional financial analysis to deliver a more informed view of how a company is managing risks and opportunities.
Factor investing itself is not new—it’s a strategy that active managers have been offering for years, often at a premium. However, as with many areas of the capital markets, its wider adoption has been accelerated by rapid advances in data science and technology. Passive managers like Ethic are now able to offer cost-effective, index-like exposures that can be tilted toward specific factors, as well as customized to clients’ preferences around ESG issues, tax management, and tracking error. From there, our sophisticated platform takes care of ongoing portfolio rebalancing to minimize active risk. It’s the best of both worlds: the flexibility and tax optimization perks of active management, with the transparency and price efficiency of passive strategies.
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This article first appeared on Entrepreneur.com as, "The Investing Strategy That Can Lower Risk in Your Portfolio."