What is factor investing?

Let’s review each of these 5 factors.

Value investing strategies select stocks that are lower cost relative to their peers after controlling for fundamentals. Think of value investing as going bargain shopping at the mall. If you’re indifferent between two pairs of shoes at different price points, for example, you should buy the cheaper of the two. It’s a similar concept for stocks. According to the 1992 findings of Fama and French, lower cost stocks have historically tended to produce higher returns.¹ Value investors are often trying to get more for their money. When evaluating stocks, investors can strive to find value by looking for relatively low prices based on common value metrics such as forward earnings or book value, for example.

Quality investing strategies look for stocks that have higher quality earnings. That means that we’re looking for stocks that are profitable, have low leverage, and demonstrate consistent earnings over time.² Think of quality investing as trying to find companies that are efficient with capital. To extend our shoe analogy, imagine two pairs of sneakers where one has cool designs and colors, and the other is just plain and grey; surprisingly, they both cost the same. In this case, I would opt for the sneakers with the cool design. Like value investors, quality investors may also be looking to get more for their money, but they often focus on the earnings generated by companies as opposed to concentrating on the company’s price.

Momentum investing is concerned with stocks that are trending in a particular direction. We’ve all heard the expression about the wisdom in crowds. The truth is you can’t have a mob without a crowd too. Sometimes investors are irrationally exuberant. Sometimes they are incomprehensibly dour. Academic research has found that stocks that have been trending upwards tend to continue to rise in the short- to medium-term; the opposite can be observed too.³ Momentum strategies evaluate stocks based on how well they have performed over the recent past, such as the trailing 6 or 12 months.

Size investing focuses on smaller, more nimble companies. Investors can evaluate how large a company is based on their market capitalization.⁴ A study from 1981 showed that small cap companies tended to outperform their large cap peers.⁵ There have been many theories on why smaller companies have historically outperformed. While they may have fewer resources than larger competitors, smaller companies may be more nimble, and can potentially more easily adjust and identify new investment opportunities in the marketplace.  

Minimum volatility investing involves building a portfolio of stocks that have exhibited lower volatility compared to the broad market. We’ve known for a long time that volatility (risk) is persistent. Investors can use this by looking at volatilities and correlations⁶ to form a portfolio that has lower expected volatility for investors. Unlike the other four factors, the goal of minimum volatility is not necessarily to enhance return, but to reduce overall risk.⁷ This can be a real boon for investors who are looking to stay invested in an asset class while managing the overall risk of their portfolio. As a bonus, there’s findings that shows more volatile stocks have historically had lower realized returns than less volatile stocks; these high volatility stocks are often more likely to be excluded in minimum volatility portfolios.⁸

Historically, the five highlighted factors have provided positive relative and absolute returns or helped reduce risk, relative to their counterparts.⁹ Value, quality, momentum, and size have all historically enhanced relative portfolio returns, while minimum volatility has consistently reduced relative risk.^7,9 Additionally, the longer the factors have been held, the higher the probability of relative success.⁹

Researchers can comb through data and sometimes find patterns that outperformed the market but lack an economic explanation. In contrast, economic study is central to factor investing.

The core of factor investing is the belief that certain traits in securities will lead to outperformance or reduced risk over the long term. This belief has been explored in academic theory and research. All factors that we believe in — value, quality, momentum, small size, and minimum volatility — have an economic rationale for why they have existed historically and why we expect them to persist going forward.

Each factor is the result of a reward for bearing risk that other investors are not willing to bear, investor behavioral biases, or structural impediments.

Some factors are rewarded for bearing higher risk. Think of small cap companies that have historically been more volatile than their larger peers. Not every investor is comfortable investing their money in a smaller company. They prefer the safety of a well-known, larger company like Apple or Google. Min vol is partially due to structural impediments. Some institutional investors are prohibited from using leverage in their portfolios — but, in order to reach high return targets, they end up overweighting more volatile companies in the hope of capturing higher returns. This may cause a persistent underweight to less volatile companies. Some factors are due to behavioral biases. Momentum is the classic example. Investors hear about friends or neighbors that made a lot of money in a certain stock, and interest in that stock grows, potentially resulting in return being driven higher for a period of time.

One question we often hear from clients: what happens if everyone knows about these factors? Will their potential benefits go away?

The short answer is, unless investors are suddenly willing to take additional risk in their portfolio, or structural impediments are removed, or investors preferences, perceptions, and tolerances towards risks of all types align – there is no reason to believe that these factors can’t continue to persist in the future. That’s the beauty of going beyond raw empiricism. Asking “why?”, even before we do the math, helps us understand if we’ve found a real signal. It also allows us to evaluate the world after the fact to determine if our logic (and our subsequent choices) still hold.

With Factor ETFs, investors can get cost-effective access to systematic sources of higher potential expected returns. And they can do so in a way that helps them reduce the guesswork. You don’t have to go stock by stock. You don’t have to figure out whether a particular manager was lucky or actually good.

But when and how might investors consider using Factor ETFs in a portfolio?

Investors have traditionally used Factor ETFs in three main ways:

• Seeking outperformance: Expecting the markets to rally? Value or small size exposure might be right for you. Think there’s strong momentum in the markets? Well… that one explains itself.
• Managing risk in a portfolio: For example, an investor working at a large technology company may look to add a value ETF to help offset the overweight to growth they currently have from their company’s stock. Further, they could aim to de-risk within their equity sleeve by using a minimum volatility ETF.
• Expressing a short-term view on markets: Worried about recession? Min vol could be used to manage risk.⁷ Worried about inflation? Companies with higher quality earnings may be worth considering for your portfolio.

There’s one more use case that really makes itself clear for investors who choose to adopt factors into their portfolios. A single vehicle that combines factor exposures can be used to form the core for your portfolio. These types of “multifactor” strategies often seek exposure to factors that have historically outperformed the broad market while also maintaining a similar level of market risk. There are a lot of benefits to investors from this type of structure. First, they can be cost effective options, for example, the iShares U.S. Equity Factor ETF (LRGF) has an expense ratio of only 8 basis points, the lowest in the industry.¹⁰ Multifactor ETFs also offer operational benefits for investors, since having multiple factors in a single vehicle can reduce the amount of rebalancing that investors need to manage themselves. Managing multiple factors internally can also help manage turnover, which can contribute to minimizing the costs of managing a multifactor fund. Additionally, the enhanced tax efficiency of the ETF vehicle also supports the after-fee and after-tax return.

In the same vein that travel websites have simplified and lessened the cost of booking a vacation, factor ETFs can have a similar effect in the world of investing. iShares Factor ETFs allow investors to capture these well vetted and tested drivers of returns — value, quality, momentum, size, min vol, and multifactor — in low cost, tax-efficient ETFs. As long as investors remain concerned about risk, structural impediments remain in place, and humans do not become robots, there’s reason to believe factors could continue to drive returns in the future.

This is part 1 of an ongoing educational series on factor investing. Stay tuned for more upcoming content on each of the underlying factors.

There can be no assurance that performance will be enhanced, or risk will be reduced for funds that seek to provide exposure to certain quantitative investment characteristics ("factors"). Exposure to such investment factors may detract from performance in some market environments, perhaps for extended periods. In such circumstances, a fund may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.