Factor investing: How it works, pros & cons

While factor investing can be beneficial in any type of market, it can be even more advantageous in more volatile markets, when individual security selection becomes more important. Choosing the right securities — based on very specific metrics — can help investors accurately select the ones most likely to perform well.

The short version:

• Factor investing is a model of passive investing that improves returns without materially increasing risks.
• Factor investing strategy evaluates securities based on five specific criteria — Size and value of stocks, quality of the companies, momentum, and volatility.
• Traditionally used for institutional investing, there are more funds available for individual investors to participate factor investing with their ETFs.

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What is factor investing?

Factor investing as a theory emerged as early as the 1960s, with the development of the Capital Asset Pricing Model (CAPM). The CAPM attempted to measure the performance of a stock or other security when compared to the underlying market. This is what is frequently referred to as beta.

Beta is a number assigned to a security that measures its relative performance to the general market. For example, a stock with a beta of 2 is considered twice as volatile as the general market. If the market rises by 10%, the stock is expected to rise by 20%.

There have been various iterations of factor of investing, and it is increasingly being used in both the creation and management of investment portfolios, particularly at the institutional level.

The five factors in factor investing

Factor investing looks at one big picture factor and five factors that affect each security individually.

The big picture factor is macroeconomic factors. These are outside events that affect the performance of both the market and the securities within them. They take into account economic growth, inflation, interest rates, unemployment, national fiscal policy, and geopolitical factors.

The five factors that apply to each individual security are as follows:

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Size

Small capitalization stocks — those with a total market capitalization under $2 billion — tend to produce higher returns over the long-term. A portfolio favoring small cap stocks is likely to provide greater growth potential than one composed entirely of large cap stocks.

However, since small cap stocks do add higher risk to a portfolio, they must be balanced accordingly.

Read: Large cap vs. mid cap vs. small cap stocks

Value

At any given moment in the market, some stocks are considered overvalued, some fairly-valued, and others undervalued. In theory at least, undervalued stocks are likely to provide better returns over the long-term. Including undervalued stocks in a portfolio should lead to greater long-term growth.

A company is considered undervalued when its stock is priced lower than its major competitors with metrics such as price-to-earnings ratio, dividend yield, price-to-book value ratio, and other factors.

Quality

This factor evaluates the quality of the companies behind the stocks of the portfolio. It favors high capital returns over lower ones. It’s a more complicated metric since it requires deeper analysis of the company’s financials.

The company should have a pattern of consistent growth, with stable earnings and low debt. It should also have one or more successful product or service lines not being offered by its competitors.

Momentum

This factor is based on the law of inertia: Objects in motion stay in motion. Applied to investments, if a stock is rising in value it generally continues to do so. Momentum measures the recent performance of the stock over a given period of time, such as one year. If the growth is consistent, the stock is considered a positive for this factor.

Risk volatility

This is where beta enters the picture. A beta of 1.0 indicates a stock is roughly 100% correlated with the performance of the underlying market. But a beta of greater than 1.0 means that it's more volatile. A beta of less than 1.0 means it has lower volatility.

One beta measure may not be better than another, but it’s useful to be aware of the beta of each security in a portfolio and balance accordingly. High beta stocks are likely to perform better than the general market in a rising environment. But they’re also likely to drop faster in a declining market.

Some portfolio managers attempt to work around this dilemma using a concept known as Smart Beta. They use a series of rules associated with factor investing in selecting securities for a portfolio.

Related: What is smart beta and how does it affect your investments?

How to participate in factor investing

Because it’s a more sophisticated investment strategy, factor investing is more commonly used with institutional portfolios, like pension plans. But that doesn’t mean factor investing isn’t available to small investors.

There are two primary ways that everyday investors can implement a factor investing strategy to their portfolios. The first is through ETFs and the second is by investing in Smart Beta portfolios with robo advisors. Here's a closer look at each option.

Factor investing ETFs

In fact, the strategy has become fairly common with exchange traded funds (ETFs), so you can participate just by investing in one or more funds.

For example, Fidelity offers factor investing with no fewer than 15 ETFs. These include the Fidelity Low Volatility Factor ETF (FDMO), Fidelity Quality Factor ETF (FQAL), Fidelity Value Factor ETF (FVAL), and the Fidelity International Multifactor ETF (FDEV).

iShares offers four different varieties of factor investing, including single factor, multifactor, minimum volatility, and fixed income. Single factor ETFs are available for value stocks (VLUE), quality stocks (QUAL), momentum stocks (MTUM), and size (SIZE).

Many other fund families similarly offer factor investing ETFs. You can participate in factor investing just by adding one or more of these funds to your portfolio. Just keep in mind that's there’s little data to indicate how well factor investing funds will perform in a protracted bear market. For example, all three iShares multifactor ETFs have been around less than 10 years.

Smart beta portfolios

You can also take advantage of the Smart Beta variation of factor investing with robo-advisors. Betterment, for example, has a Goldman Sachs Smart Beta Portfolio option.

These funds equally weight the four following factors: good value, high quality, strong momentum, low volatility. Betterment says that these funds are intended for investors who “wish to attempt to outperform a market-cap portfolio strategy in the long term despite potential periods of underperformance.”

Factor investing pros & cons

Pros

• Relies on passive investing but tweaks the model to improve returns without materially increasing risks
• Provides more portfolio customization than purely passive investing
• Uses a systematic investment approach that removes emotion from the decision-making process
• Gives investors the ability to accept higher returns in exchange for greater volatility, or lower returns with less volatility than the overall market

Cons

• Only available with select funds
• Due to the algorithmic nature of factor investing, it would be difficult to duplicate by small investors using the do-it-yourself approach
• The strategy is fairly complex and not all funds employ all five factors
• Many factor investing funds have short histories and have yet to face long bear market periods

Bottom line

Though factor investing appears to be an interesting concept with plenty of potential, there’s little hard evidence that it outperforms more conventional strategies in either bull markets or bear markets. The various theories have been around for about 60 years. But a very specific winning formula appears to be elusive.

Investors should also be aware that there’s no single type of factor investing funds. There are now funds that invest based on single factors, all five factors, or in specific market sectors, like U.S. or international stocks, or fixed income investments.

If you’re interested in factor investing, consider investing only a small slice of your portfolio into one or two funds. If you find success with those funds, you can expand your exposure.