What is a Factor Based Portfolio?
Investing

What is a Factor Based Portfolio?

Investing
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A factor based portfolio is an investment portfolio that uses “factors” to increase diversification and drive returns. Factors are features of a stock, bond, or security that are known to drive high returns, such as the ratio between growth and value, or the market sector of a company. Factor investing is a way of building well-diversified portfolios that can also provide better returns than broad, market-tracking ETFs or index funds.

Up until quite recently, factor investment and factor based portfolios were only available to elite or institutional investors with millions of dollars under management. Today, you don’t need anywhere near that amount of capital to start using factors. Active investors who would like to take advantage of this approach can use a number of off-the-shelf factor investment funds, such as those offered by Blackrock and Vanguard.

There is also a solution for investors who want to build a factor portfolio, but also stay in control of their money. This is Wealthface. Using our platform, active investors can build a portfolio around one factor or a combination of factors, buy fractional shares to ensure their portfolio stays balanced, and explore potential returns in real time.

Key Takeaways:

  1. Factor investing is an investment strategy that can help you build a diverse, high-return portfolio.
  2. Factor investing uses known drivers of growth – known as “factors” – to build investment portfolios that are diverse, but which are also designed to outperform the general market. 
  3. There are several popular strategies which are used for factor investing, including value investing and smart beta. You can use the Wealthface platform to build a portfolio based on one or many factors, and take advantage of an investment strategy that has until now only been available to elite investors.

How do I build a smart portfolio and start making money?

When it comes to building an investment portfolio, active investors must strike a balance between two competing factors.

On the one hand, smart investors know that diversification is an important way of reducing risk. By having a well-diversified portfolio, investors are protected against short-term reductions in the value of particular assets, as the value of their portfolio will track that of the market (or sector) where they are active. On the other hand, portfolios which are too diverse can limit the gains realized by institutional investors. This is because a “perfectly diverse”  portfolio will change in value in a way which is perfectly in step with the market. If the whole market moves up 1%, so will your portfolio, but your portfolio will also reduce in value if there is a broad downturn in the market.

Factor investing is a way to approach this compromise intelligently – allowing you to build a portfolio that is both diverse and high-reward.

What is Factor Investing?

Factor investing uses “factors”. These are broad, persistent, and long recognized drivers of returns that are built up from the data available on a particular stock or bond. For instance, it’s long been known that the ration between the recent growth and the current value of a stock is a good predictor of how it will move in the long term. This ratio is known to factor investors as a “factor”, and is the basis for one of the most popular factor investing strategies.

Factor investing can seem complex to investors new to the strategy. It’s certainly more complex than strategies such as the “60% stocks, 40% bonds” approach. But factor investing is also more sophisticated than these approaches, and allows investors to gain a deeper insight into the stock and bonds they are putting their money behind.

Some of the factors used by institutional investors can indeed be very complicated. However, there are also a number of powerful factors that can be calculated (or merely accessed) quite easily. To begin with, it’s important to recognize that there are two different types of factor – style and macroeconomics.

Let’s take a look at each type in more detail.

Style Factors

Style factors are a number of factors that aim to explain why some assets perform differently from those in the same industry and asset class. They relate the fundamental value of an asset to its current market price, typically by looking at the health and management of the company which is being invested in. 

Examples of style factors include:

  • Value: Sometimes, stocks are discounted relative to their fundamental value.
  • Low volatility: Stocks which have proven to be stable over the medium term are valuable for active investors, making this an popular factor.
  • Momentum: This factor measures the direction in which an asset is moving, and at which velocity.
  • Quality: A factor which looks at how well run a company is, and uses this to predict the future value of its stock.
  • Size: An important element for many investors is the size of the company they are investing in.

All of these factors can be used to predict the movement of a particular asset, and crucially the movement of an asset in relation to similar assets. Because of this, style factors can be a powerful tool for active investors looking to make medium-term gains.

Macroeconomic Factors

There are also a number of factors that don’t relate directly to the company or commodity behind a stock or bond, but instead reflect the market conditions which every asset has to contend with. These factors tend to change more slowly than style factors, but can still be excellent predictors of value in the medium term.

Examples of macroeconomic factors include:

  • Economic Growth: Some stocks and bonds are more exposed to the macroeconomic business cycle than others, and this is an important element in their performance.
  • Real Rates: Similarly, some assets are more affected by central banks varying interest rates. This factor measures this exposure, and puts a definite value on it.
  • Inflation: Inflation effects different assets differently, but this is often overlooked in less sophisticated investment strategies.
  • Credit: By looking at the default risk of a particular company, this factor aims to give investors a more realistic understanding of the risk of an asset.
  • Liquidity: Conversely, the liquidity factor aims to express and quantify the value of a company having easy access to liquid funds.

Just like style factors, these macroeconomic factors can be an accurate predictor of the movement of a particular asset. All of these factors aim to measure the impact of macroeconomic shifts on the value of individual stocks and bonds, and to explain why a particular security will perform better than its peers under the same macroeconomic conditions.

Why Factor Investing?

The reasons why active investors should use factor investment approaches are pretty clear – factors help to explain why particular assets increase in value relative to the market, but can also be used to build portfolios that perform well across a range of macroeconomic conditions. This means that factor based portfolios can represent the best of both worlds – an investment strategy that is both diverse and high-return.

This is why two of the biggest institutional investors in the world – Blackrock and Vanguard – now offer factor based ETFs. These investment funds use a wide variety of factors, both style and macroeconomic, to offer investors well-balanced portfolios that claim to also offer high returns. However, these funds are one-size-fits-all affairs, and are better suited to wealthy investors.

For active investors who want to take a more hands-on approach, and to design their own factor based portfolio, there are other options available. One of these is Wealthface. 

Our platform allows investors to design their own factor based portfolios. Using our system, you can design a portfolio based on just one factor, or on many. You can access data that indicates how your portfolio would have performed over the last few years, and then when you are ready buy assets directly. Think of it as building your own factor based ETF, in which you control the shares you are investing in.

Wealthface is also available to the whole range of investors – from those with millions of dollars to those who want to see what they can make with $100. With our system, you can design a factor based portfolio, and then automate the process of buying fractional shares in the assets you have specified. This way, you can put as little (or as much) as you like behind a particular strategy. 

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Wealthface: Your Factor Investing Solution

Factor investing is a powerful approach to building portfolios that are diverse but also offer high returns. Unfortunately, this approach has only been available to elite investors. Until now.

Wealthface offers active investors an easy, affordable way of building a factor based portfolio. Using our platform, you can design and compare factor investment strategies, and then automate the process of buying the necessary assets. 

Our mission is simple. We aim to turn what was once an expensive, complex, elite investment strategy into one which is affordable, easy, and available to every investor.

Wealthface smart financial tools will help you shape your financial future.
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