The world of investing has changed drastically over the past few years as more data and technology became available to investors. One of these strategies that is leading right now is factor investing. More recently, factor investing strategies reserved for institutional investors and hedge funds are growing increasingly available to retail clients. This opening up of sophisticated investment strategies is transforming the personal finance landscape and creating new opportunities for your average Joe investor to increase returns.
What is Factor Investing?
The investor who wants to outperform the market without taking extra risk should look for factor investing. These drivers, or “factors” are traits and behaviors that help to explain why securities earn different returns. Some of the main reasons are:
Value: This style revolves around picking stocks that are cheap in their fundamental performance.
Momentum: Stocks with impressive performance recently.
Quality: Favouring companies with strong balance sheets and stable earnings.
Size: Concentrating on smaller firms which can have greater growth potential.
Invest in Lower Volatility Stocks — this strategy means that you are buying and selling stocks with less price fluctuation, which will help maintain safety inactive stock investments.
Yield — Investing in higher dividend stocks.
In using the factors as a part of their portfolio construction, investors are looking to capture returns that can be linked and attributable to these asset-level characteristics rather than strictly broad market exposures.
The Rise of Factor Investing for Retail Investors
Factor investing, however, was traditionally too data-intensive and required too much research to be adopted by the average investor. But factor investing was for a long time the exclusive domain of institutions until several recent developments made it more accessible to retail investors.
1. Exchange-traded funds (ETFs)
Factor-based ETFs have launched a revolution of sorts. These types of funds give investors exposure to individual factors or combinations of them and make it easy for retail clients to add factor strategies to their investment programs without doing a lot of analysis or stock picking.
2. Robo-Advisors
In today’s marketplace, there are a variety of robo-advisory platforms providing factor-based portfolios through their service offering. These robo-advisors, with their use of algorithms to build and manage portfolios following factor strategies, provide low-cost access to sophisticated investing.
3. Improved Data Accessibility
However, it was the democratization of financial data and analysis tools that allowed retail investors to independently do their factor research and implement strategies.
4. Educational Resources
The availability of educational content on factor investing has also eased a lot of the mystery surrounding these strategies for retail investors, improving what once seemed more esoteric.
Benefits of Factor Investing for Retail Investors
While not a panacea by any means, factor investing can provide retail investors with several potential benefits:
Furthermore, Enhanced Returns — if investors can identify the right factors then they may potentially achieve returns over those provided by the broader market.
Diversification: Factor strategies can offer diversification benefits further than those found in traditional asset allocation, potentially helping lower portfolio risk.
Factor-based strategies can combine elements of both active and passive investing, but the funds are still far more transparent than traditional active management approaches; investors know enough about how their returns should be generated.
Expense Savings: Most factor-based ETFs are cheaper than traditional active funds and robo-advisors tend to be less expensive.
Discipline: Factor investments are based on risk characteristics and provide a system-driven, rule-based methodology that can help remove market emotions from the investment.
Challenges and Considerations
Factor investing provides many advantages, but retail investors should be aware of potential pitfalls:
Complexity: For all the progress it has made, factor investing isn’t simple. Staying educated about how these and other factors interact with one another will help you gain an insight into why future returns unfold the way it does.
Performance Cycles: Factors that may experience long periods of underperformance. Investors need to be able to think long-term and have the patience to stick with their investing style through different market cycles.
Cost (Implementation): On the whole, factor strategies are inexpensive to uniquely own however in some instances frequent rebalancing can result in increased trading costs and unintended tax consequences.
Data Dependence: The power of factor strategies is highly dependent on the quality and timeliness of data available. The retail investor often does not have the latest or best data sets.
Factor investing overcapacity risk: Factor-based investment may eventually become overcrowded and less profitable for selected factors.
Getting Started with Factor Investing
If you’re a retail investor interested in going down the path of factor investing, here are some next steps to consider:
Self-Educate: Spend time learning how these factors work and their historical performance.
Start Small: Begin Small Allocate a small percentage of your portfolio to factor-based strategies to get used to — and comfortable with investing using factors.
Thus utilizing ETFs or Robo-Advisors to implement the factor strategies might be a good idea for someone who does not want to perform all of that extensive analysis.
Monitor and Rebalance: Monitor your factor risks and rebalance if necessary to ensure that you are maintaining the desired levels of each.
Anyone interested in factor investing needs to stay abreast of advances and be willing to change their strategy.
Conclusion
Factor investing is one of the key milestones in the democratization of advanced investment strategies. By granting retail investors the same access to return drivers only available historically to those who invest via institutions, factor investing enables these managers to have a potential edge on both returns and possibly better manage their risk within their portfolio. But just like any investment strategy, it’s important to have a deep understanding of the approach and what possible advantages come with the caveats. As the field of factor investing matures and opens, it may change how retail investors think about building and managing a portfolio in future years.