Factor investing is a systematic strategy for investors who want to move beyond standard market capitalization-based approaches. Rather than simply investing in all the stocks of a broad index, like the S&P 500, factor-based investing can focus on quantifiable drivers of returns, known as factors. Research and historical data show that factors such as value, momentum, and low volatility may deliver consistent outperformance over time.

This article explores factor investing strategies, how to construct a factor-based portfolio, and ways to integrate this approach with other investment styles. Factor investing can be a complicated process and involves risk. Factor’s don’t always work and isn’t for everyone. Similarly to other investment decisions, you should always research your options before making any decisions. If you are unsure, consult with the appropriate professional. 

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What is factor investing?

Factor investing is an evidence-based investment strategy that focuses on measurable characteristics, or factors, that can explain differences in stock returns. Instead of investing passively in a broad index or reacting to market news, factor investors aim to achieve “alpha” — market outperformance. There are several widely recognized factors, including: 

• Value: Value stocks are considered undervalued relative to fundamentals and their peers. They are often identified by low price-to-earnings (P/E) or price-to-book ratios.
• Momentum: Stocks that have recently outperformed tend to continue performing well in the short term.
• Size: Smaller companies, or small cap stocks, historically outperform larger companies over the long term – although tend to have greater volatility. 
• Low volatility: Low-volatility stocks fluctuate less than the broader market, which can help reduce risk for more conservative investors. 

What is a factor stock and factor portfolio?

A factor stock is a security that exhibits one of the measurable characteristics used in factor investing. For example, a company with a low P/E ratio relative to its peers may be considered a value factor stock. A stock that has steadily appreciated in price over the past year could be classified as a momentum factor stock. Similarly, a company with a market capitalization generally between $300 million and $2 billion qualifies as a size factor stock. These equities can serve as the building blocks of a factor-based investing strategy. 

A factor portfolio is a group of invested assets, such as factor stocks, selected and weighted according to factor exposure rather than market capitalization. Unlike passive funds that track broad indexes, factor portfolios can determine each stock’s weight based on how strongly it exhibits the desired factors. Factor portfolios follow systematic rules to select and purchase stocks with the primary goals of market outperformance, improving diversification, and — in some cases — providing volatility protection. 

3 factor investing strategies

Factor investing typically takes shape once you identify factor stocks. The strategy you choose depends on your risk tolerance, time horizon, and investment goals. Here’s an overview of three key strategies.

1. Single-factor tilt

The single-factor tilt strategy focuses on just one factor, making it the most straightforward approach. This method generally starts with a market-capitalization-weighted index and slightly over weights stocks that show higher exposure to the chosen factor. For example, an aggressive investor might use momentum as the single factor, whereas a more conservative investor nearing retirement may favor low-volatility stocks. 

2. Multi-factor portfolio

A multi-factor portfolio incorporates several uncorrelated factors in one strategy. This approach can be beneficial for long-term investors, as it reduces reliance on the performance of any single factor. For instance, if value stocks underperform, other factors such as momentum or low volatility can help maintain overall portfolio performance. Multi-factor strategies are less dependent on precise market timing compared with single-factor tilts. 

3. Dynamic factor timing

Dynamic factor timing is the most sophisticated strategy. It seeks to predict which factors will outperform in the short and intermediate-term and adjusts exposures accordingly. Portfolio managers analyze economic data, such as GDP growth, inflation, and market conditions, to favor the factors they expect to perform best in a given environment. This strategy requires active management and careful monitoring of both markets and economic indicators.

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How to create a factor portfolio step by step

Factor investing follows a rules-based approach. Here are the steps investors, financial advisors, and institutional money managers typically follow when creating factor portfolios. 

1. Define investment goals

The first step is to determine your objectives in relation to your time horizon and risk tolerance. If you’re close to retirement, a factor portfolio that favors low volatility or high-quality blue-chip stocks may be appropriate. For investors with a long-term time horizon and a more aggressive risk appetite, factors such as value and size, which can outperform over time, may be suitable.

2. Asset selection

Once you’ve defined your investment goals, the next step is selecting the individual stocks. If your portfolio emphasizes value, you might only include the cheapest 25% of stocks by P/E ratio within a specific universe, such as the S&P 500. This filtering process ensures that the portfolio strictly reflects the intended factors.

3. Portfolio weighting

Portfolio weighting is what sets factor-based investing apart from passive management. Stocks that most strongly exhibit the chosen factor or factors receive greater weight in the portfolio. You may apply additional rules to manage risk, such as capping exposure to a single stock at a fixed percentage of the portfolio.

4. Rebalancing

As with any investment portfolio, factor portfolios require ongoing monitoring and adjustment. Economic conditions, interest rates, and change in individual stock characteristics can all affect factor performance. Managers may make major strategy adjustments or smaller tweaks, such as rebalancing exposures or removing certain equities. The key is to ensure that your factor-based approach remains aligned with your investment goals as your financial situation evolves. 

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This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Guarantees are backed by the financial strength and claims-paying ability of the issuer.

Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results.