Factor investing is all about targeting specific drivers of investment returns, whether in the economy at large or in individual companies. At the same time, factor-investing fund managers aim to limit the impact of specific risks.
Investments can be made across different asset classes, including stocks and bonds.
Capital at risk. The value of investments and the income from them can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested.
Introduction to factors
In many ways, factors are the foundation of investing. With every investment, fund managers consider elements – whether in individual companies or the economy as a whole – that they believe will lead to strong returns and reduce the risk of their clients losing capital.
But when we talk about factor investing in particular, which factors are we referring to?
Types of factors
There are two main types of factors that can drive returns:
- Macroeconomic factors – Aspects of the wider economy that the manager believes will lead to higher returns in specific asset classes and industries.
- Style factors – The potential risks and returns associated with specific factors within asset classes, such as stocks and bonds.
Risk. There can be no assurance that performance will be enhanced or risk will be reduced for strategies 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 strategy may seek to maintain exposure to the targeted investment factors and not adjust to target different factors, which could result in losses.
More about factor investing
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Because factor investing may provide strong returns, help lower exposure to poorly performing segments of stock and bond markets, and enhance diversification when combined with other investments.
Factor investing is not new, but data and technology have given more investors access to these often-profitable investment strategies.
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When it comes to factor-based strategies, investors have a lot of options. Each strategy is constructed in a personalised way and each will come with its own level of investment risk. It’s important that investors understand what factors their fund is exposed to, and the trade-off of risks and potential returns.
The risk associated with shorting in factor strategies
Many factor strategies use long-short investing, which involve buying stocks (going long) that are expected to perform well and selling stocks (going short) that are expected to perform poorly. When an investment manager employs shorting, they “borrow” a stock that is projected to decline in value, sell it and then buy it back for a lower amount. This way, the fund manager can make returns from both factors they expect to perform well and factors they expect to perform poorly. However, such factor strategies often borrow funds in order to make investments, which could mean high returns, but could also lead to higher losses if investments perform poorly.
Risk: The Fund may engage in short sale transactions. Short sales, in certain circumstances, can substantially increase the impact of adverse price movements on the Fund’s portfolio. A short sale of a security involves the risk of a theoretically unlimited loss from a theoretically unlimited increase in the market price of the security that could result in an inability to cover the short position
Be aware of the factors your fund is invested in
The factors a fund is focused on may not always perform well. For example, a factor that is making investment based a high rate of inflation may perform poorly when inflation falls. A multi-factor investment that is diversified across different factors may offer a lower level of risk than a fund with a more-focused factor investing strategy.
Risk. Diversification and asset allocation may not fully protect you from market risk.
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Investors can also take advantage of passive methods of factor investing. Smart beta is one such method, which aims to combine the lower costs of passive investing (tracking a stock or bond index) with optimisation techniques to take advantage of factors in stock or bond markets that the fund manager believes will perform well and avoid those factors they believe will perform poorly.
Smart beta funds generally do not employ long-short strategies, only invest in one asset class and will not borrow funds in order to invest. They are most commonly accessed through exchange-traded funds (ETFs), which are investment funds that are traded on a stock exchange.
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One of the most pervasive myths around factor investing is that it must be used instead of traditional active and passive stock and bond funds.
Factor-based strategies, including passive factor products, such as ETFs, can be used both to replace and to complement traditional investment strategies.
This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy.
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