Over the last couple of decades, factor investing (or smart beta) has made a big splash in the investment community. This approach aims to discover and exploit individual traits, or “factors”, that are responsible for returns among similar types of investments. Looking at the next 10 years, there are a few major trends that I believe will define factor investing for many investors and half-investors.
1. Increased Sophistication and Customization
Increased Innovation, Greater PersonalizationOne of the most important trends that could emerge is greater levels of innovation and customization in factor strategies. Investors, therefore, should have a greater choice over the coming years in terms of factor exposures as our understanding of factors expands and data analysis tools become more sophisticated.
Prediction: The rise of increasingly sophisticated, personally tailored factor strategies that can be better calibrated to investor goals and market conditions should accelerate by 2030. Those algorithms will apply also those strategies that have more sophisticated and multi-dimensional factors, not just limited to value, momentum, and quality.
2. Integration of Machine Learning and AI
Factor investing, like many other corners of finance, will soon be shaken up by the development & widespread adoption of artificial intelligence and machine learning. Using these new technologies, we could identify the factors more efficiently or improve our understanding in terms of factor interactions and performance prediction.
Predictions: over the next 5 years, AI-driven factor models will become ubiquitous and outperform existing static approaches.
3. Expansion into New Asset Classes
Factor investing has been most closely and commonly associated with equities, but the use of factor strategies of a broader swath across asset classes is undoubtedly on the rise.
Forecast: factor investing has been extended beyond equity to fixed income, commodities, and eventually alternative assets such as real estate and private capital by 2025. The extension will allow asset owners the ability to further diversify with real assets and additional sources of alpha.
4. Greater Focus on ESG Factors
Environmental, social, and governance (ESG) considerations are increasingly important to investors. This trend will probably intersect factor-based investing in important ways.
Prediction: ESG factors will be included within all mainstream factor models by 2028; many existing equity (and credit) themes can only persist as long as increasing companies in the space of things that deplete sustainability cause no harm to portfolios against competing strategies.
5. Democratization of Factor Investing
With more accessible and understood factor investing strategies, the adoption from retail investors should be greater.
Predicted: Factor-based ETFs and mutual funds (and low-cost solutions) will be just as prevalent for retail investors in 2030, hopefully much more so than traditional index funds are now. We would not be surprised to see robo-advisors begin offering factor-tilted portfolios as their primary option.
6. Evolution of Factor Timing Strategies
While there is no doubt regarding the long-term performance of factors, their readjustment over shorter timeframes has been highly variable. Accordingly, this will likely further focus attention on factor timing strategies.
Prediction: In at least 20 to 30 years, sophisticated factor rotation strategies will become so accessible that investors can automatically alter the weights of their factors based on market conditions and expectations for individual factor performance as early as say…oh, I don’t know…2027.
7. Enhanced Factor Research and Discovery
With factor investing becoming an increasingly competitive space, there will be even more pressure to find additional factors that are non-correlated (ideally negatively) with the inflation and momentum risks outlined in my previous blog.
Forecast: Over the coming decade, I expect there to be a few new accepted factors — perhaps having something to do with corporate culture, innovation capacity, or exposure to geopolitical risk.
8. Increased Regulatory Scrutiny
With the rising popularity of factor investing, it shall only garner further scrutiny from regulators worried that issues such as systemic risk and market impact may come up to the surface.
Prediction: By 2026, we will have regulations for factor-based investment products too, and may include mandates concerning better disclosure of behavior-factor exposures.
9. Integration with Traditional Active Management
The line between factor investing and traditional active management will probably be increasingly blurred in the years to come.
Prediction: By 2029, just about every active manager will be overt in their application of factor analysis within investment processes with performance attribution slicing returns between factor and non-factor alpha.
10. Globalization of Factor Strategies
The previous chart is based on developed markets in general and especially the U.S.A., but expect more research into what factors drive returns for emerging, respectively frontier market stocks.
By 2030, expect all factor strategies to dynamically allocate across the developed and emerging worlds as opportunities in factors evolve (PREDICTION)
Conclusion
Factor investing still has its best decade ahead of it. With strategies growing increasingly sophisticated, accessible, and universal in application, they may indeed be destined to reshape the entire investment landscape. Nevertheless, just like with any investment approach, investors need to monitor the latest evidence and evaluate whether factor strategies are compatible with their broader investing objectives and tolerance of risk.
Much as the above predictions offer, at best, a tantalizing glimpse into the future for factor investors we should perhaps remember that financial markets are to an extent unpredictable by their very nature. Factor investing is not an absolute concept: the momentum of new technologies, changing regulations, or unforeseen economic events could dramatically reshape its trajectory. Dealing with (a) Changing Investment Landscape(s): Once more, finding the right balance and staying abreast of the latest information will be central to effective investing.