3 things every investor should know about factor investing

One of the more confounding investment terms in common use today is “factor investing.” In this article, we discuss the significance of factor investing and why it matters to investors.    

When an investor sits down with a financial professional to formulate an asset allocation plan, the focus is frequently on asset classes, stock picking, and how to balance active and passive investment approaches. While this exercise can be fruitful and yield important insight into an investor’s objectives and risk tolerance, it’s not the only—or necessarily the best—way to come up with an asset allocation plan.

Financial researchers over the past 40 years have sought to find more fundamental factors that explain what drives certain types of stocks to have higher expected returns. Some of these factors are now broadly recognized as quantifiable building blocks of market returns, and when looked at from the standpoint of asset allocation, factor investing offers a compelling alternative for building portfolios.    

The first thing you should know about factor investing is that it may already be a part of your investment plan. Investors frequently make implied factor bets through the lens of other, more conventional investment choices. Anyone who’s allocating a portion of their portfolio to smaller-cap stocks may be tilting their portfolio toward what’s known as the size factor; similarly, anyone investing in value stocks may or may not benefit from the so-called value factor’s presence in their portfolio.    

Some of the more widely recognized factors today include size, momentum, value, and profitability; these are characteristics that (in some cases) decades of academic research support as present in the market. In other words, these attributes have been found to be persistent across market cycles—and across geographies, and so they’re claimed to be reliable drivers of long-term stock returns.

True factor-based investment strategies entail making a committed—and studied—allocation to a specific factor with the purpose of capturing the market premium associated with that factor. To capture the size premium, for example, doesn’t mean you can just allocate to a small-cap portfolio that tracks (or that seeks to outperform) a common small-cap index such as the Russell 2000 Index.

To capture as much of the small-cap premium as possible requires an approach that seeks to systematically isolate the size factor—in the absence of guesswork or stock picking. This endeavor involves setting up a rules-based system for establishing and maintaining exposure to stocks that possess or best represent the factor—even as stocks move in and out of indexes based on size, style, geography, and economic sector. Smart beta investment strategies typically seek to do precisely this.    

The second thing you should be aware of is that factor investing can be a useful tool for diversification. In other words, it opens a new way for investors to establish more precise exposures to—and unique ways of combining—complementary risks and opportunities.

One common approach in factor investing is to offer multifactor strategies that seek to capture the premiums associated with more than a single stock characteristic. The difference that such factor-based strategies seek to make can really add up. Some research has suggested, for example, that, from 1964 to 2017, smaller-cap stocks—and more specifically, smaller caps that exclude lower-profitability small caps—represent a monthly average premium of 0.36 percentage points over the broad equity market return.¹ Compounded over 5, 10, or 20 years, that modest-sounding variance could make a significant difference for virtually any portfolio.

In this way, combining multiple factors—such as size and profitability—in one or more strategies in a portfolio can help ensure a more precise degree of diversification and potentially produce better outcomes for investors.    

With factor investing, financial market researchers claim to have put their finger on something timeless in the markets—and market participants have taken note. A growing number of major asset managers include factor-based investment strategies among their product offerings. Large institutional investors, endowments and foundations, and sovereign wealth funds increasingly include factor-based strategies in the mix of their asset allocation. Factors, the theory argues—and many have come to believe—have always been, and will always be, present as key drivers of stock returns.

In support of this idea, research has shown that the longer an investor maintains exposure to a factor, the more likely that factor is to deliver a positive result. Over rolling one-year periods since 1964, small-cap stocks, for example, delivered a positive premium over larger stocks nearly 54% of the time. Stocks with low relative prices and high profitability, meanwhile, each outperformed their counterparts about 60% of the time. When these holding periods are increased to rolling ten-year periods, the chances of the equity market, size, value, or profitability factors outperforming jump to at least 74%.² 

While past performance doesn't guarantee future results, we believe this data makes a compelling case for a factor-based approach: Not only do some factors have a better likelihood of outperforming over the short term; over longer periods, the probability of a positive premium increases significantly.    

1 “Understanding the performance of small-cap stocks,” Dimensional Fund Advisors, 2018 (working paper).

2 John Hancock Investment Management, Morningstar, Ibbotson, Professor Kenneth R. French, 2016. 

3 Robert Novy-Marx provides consulting services to Dimensional Fund Advisors LP.