Benefits of Factor Investing
What is factor investing?
Factor investing is an investment strategy that involves targeting assets based on a set of factors, in order to improve portfolio outcomes, reduce volatility and enhance diversification.
Investors who want to follow a factor investing approach should identify characteristics that they look for in a stock. The characteristics are what they believe will be indicative of a stock’s success in providing high returns.
What are the factors?
Factors are the drivers of returns across asset classes. It’s beneficial for any investor to understand how factors work in order to take advantage of their potential for excess return and minimized risk.
Types of factors
There are two main types of factors: macroeconomic factors, and style factors. These two factors are drivers of returns, which impact the returns of assets across different asset classes.
Macroeconomic factors: capture broad risks across asset classes
Style Factors: help to explain returns and risk within asset classes
- Economic growth
As the economy grows, along with consumer spending, companies will be capable of increasing their profits, thus improving the stock market’s performance. On the contrary, a downturn in the economy makes it hard for companies to earn profits, leading to a decline in stock prices.
This factor deals with the exposure to changes in prices. It affects stock prices since it has an impact on how much consumers spend. When the cost of products increase, consumers will spend less. On top of that, businesses will get affected as well because consumers are not willing to make a lot of purchases.
Factor investing based on a company’s credit involves investing in stocks that provide compensation for the investor for holding onto a stock with default risk.
- Interest Rates
The rise of interest rates prevents businesses and individuals from borrowing money or taking out loans from the bank. This causes a slow down in consumer spending and economic activity.
What are the Benefits of Factor Investing?
Previously, the usage of factors to manage portfolios was only limited to institutional investors and active managers. However, now Fintech and technology have democratized factor investing thus giving all investors access to these historically persistent drivers of return.
Therefore, factor investing has proven to produce high returns due to the strategy of a stock’s traits that have historically generated positive earnings. So, by experience, investing in assets that use factor investing can help enhance returns, reduce risk, and improve diversification.
This has been also beneficial to investors due to the possibility of diversification and minimization of a portfolio’s exposure to risk, provided by factor investing, which minimizes. Factors can improve diversification since style and macroeconomic factors cover various situations in the economic cycle.
Factor investing involves investing on the basis of factors determining returns and risks, thus helping pursue three main investment goals:
- Improved outcomes of portfolio
- Reduced volatility and
- Increased diversification of the investment
4 ways to benefit from factor investing
Factor investing has proven to be one of the best and most efficient investment strategies. While using factors to invest, you must be certain you’ll be achieving the following:
Before factor investing, building a portfolio of stocks used to be related to the research done by fund managers where they studied how a specific company is doing compared to its competitors and its management, while analyzing the reasons behind the performance of a sector or a company and how it is likely to do well in the future.
Instead of going through all that traditional process, factor investing has become a rule-based investment strategy that strategically selects stocks having specific attributes.
If we take the momentum factor as an example, we can notice how it would rank all the stocks in its universe based on momentum score and then rank the stocks and give them weights. Thus, these weights could be either equal-weighted or weights dependent on its momentum score.
2) Low cost
Codifying the rules and identifying appropriate opportunities are two aspects of factor investing. As a result, managing the portfolio doesn’t involve much effort from the fund manager. Because of this, factor investing is less expensive than a traditional active investment strategy.
You may have noticed that your entire portfolio becomes in red whenever the market is down. This is only because you are putting all of your eggs in one basket.
Suppose that you have only invested in businesses in particular industries or market capitalizations, this will affect your returns for sure. On the other hand, factor investing can be more beneficial in such situations.
Thus, you get a well-diversified portfolio when you invest in a multi-factor fund where the factors are less connected. As a result, when one factor is ineffective, another one might, saving you from becoming a victim of a market decline.
4) Eliminate human bias
The presence of emotions and human bias is one issue with investors used to facing traditional investments. Your judgment may play some role in your choice especially when it comes to selecting stocks. You can invest in underperforming stocks or miss out on stocks that are genuinely performing well.
Additionally, you might be afraid if the market is sinking or become over excited if it is rising. Traditional investing frequently experiences this domination of human emotions.
You could contend that because the fund manager is transparent about his investment tools and strategies, investing through mutual funds may eliminate this bias. Here, we are neglecting the fact that even money is handled by people, controlled by emotions.
Biases are possible no matter how strategic a manager is. This issue is resolved by factor investing, which excludes human bias and qualifies the stocks using reason and scientific strategies.
Why choose Wealthface for factor investing?
Wealthface has been proactive in providing factor-based investing and making it accessible to all investors anytime and anywhere. Wealthface offers a variety of ways to implement the time-tested principles of factor investing. These include Factor ETFs, which offer low-cost, efficient access to factors, to multi-asset, multi-factor strategies, that incorporate Wealthface active insights, and invest across asset classes.