Understanding Investment Factors and Factor Investing

Key Takeaways:

• In factor investing, investors study statistical similarities between investments to find common factors they can leverage to enhance portfolios.

• Factors can include size, value, quality, and volatility of an investment opportunity.

• Factor investing can potentially help investors benefit from diversification.

When it comes to deciding where to allocate capital, many investors favor a systematic approach, which helps to inform and empower decision-making. One example of such an approach is factor investing, in which investors study statistical similarities between their investments to find common factors they can leverage. This method is widely considered to be a solid investment strategy.

Read on to find out about factor investing.

What are Investment Factors?

Quantifiable and targeted characteristics, such as share liquidity and gross domestic product growth that can explain stock return disparities are referred to as investment factors. The thought goes back to 1976, with Stephen A. Ross’ arbitrage pricing theory. This philosophy maintained that multiple factors explained security returns.

Since then, academics and investors have identified several investment factors.

Main Investing Risks

Factor investing seeks in part to mitigate risk. These include market, liquidity, credit, reinvestment, inflation, concentration, and time horizon risks. The factor investment approach is considered a way to offset prospective risks by targeting consistent, broad, and long-established drivers of returns.

The Systematic Approach

Systematic investing focuses on scientific testing, data-driven insights, and disciplined portfolio establishment to evaluate the potential of an investment opportunity. Successful investors often use this strategy to gain varied portfolio outcomes.

What is Factor Investing?

A systematic approach strategy, founded on the study, selection, weighting, and rebalancing of investment portfolios is referred to as factor investing. The emphasis is on stocks that have been shown, overtime, to improve risk-adjusted returns.

Investors can uncover factors by using rules-based exchange-traded funds to track custom indexes. They may also do so using quantitative, actively managed funds.

Economy-related factors include:

• Gross Domestic Product. Investment decisions can be based on factors such as whether the economy is expanding or contracting and consumer spending trends. The rise or fall in the prices of goods and services is another consideration.
• Inflation. An inflationary economy can have a deleterious effect on fixed-income securities.
• Interest rates. The stock market tends to fall when interest rates rise.
• Unemployment. Jobless numbers can help investors judge the overall economic climate.

Asset-Related factors include:

• Size. Historically, portfolios comprised of small-cap stocks have had better returns than portfolios with only large-cap stocks.
• Value. A prevailing view is that value investing is successful because stock performance tends to follow earnings over a period of time.
• Quality. Investors look upon a company showing stable earnings, low debt, robust corporate governance, and consistent asset growth favorably.
• Volatility. Empirical research suggests low-volatility portfolios have the potential to outperform the broader market.

Factor Investing Pros and Cons

As with any type of investment strategy, there are pros and cons for factor investing:

Pros:

• Increased potential for better returns because the approach follows a stock’s positive traits.
• Reduced investment volatility.
• More investment diversification, which generally minimizes risk exposure.
• More discipline and less emotion guiding investing practices.

Cons:

• Investors risk over-indexing on just one or two factors, also called concentration risk.
• Analyses of investment factors can be overly complex.

Factor Investing and Diversification

In addition to the potential generation of above-market returns and risk management, factor investing was designed to enhance portfolio diversification. While no investment approach is risk-free, ownership of multiple assets that perform differently can mitigate overall portfolio risk.

Smart investors favor an investment mix that is not wholly dependent on the stock market. The online alternative investment platform Yieldstreet, for example, focuses on creating predictable secondary income streams across asset classes including art and commercial real estate.

The idea is to reimagine wealth creation to help investors produce income outside of traditional public markets.

Alternative Investing and Portfolio Diversification

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings.

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk.

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million. These people were more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened several carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Factor investing is a systematic investing approach that can be mixed with other investment approaches and techniques, including adding alternative assets to investment portfolios that have low correlations to volatile markets.

All securities involve risk and may result in significant losses. Alternative investments involve specific risks that may be greater than those associated with traditional investments; are not suitable for all clients; and intended for experienced and sophisticated investors who meet specific suitability requirements and are willing to bear the high economic risks of the investment. Investments of this type may engage in speculative investment practices; carry additional risk of loss, including the possibility of partial or total loss of invested capital, due to the nature and volatility of the underlying investments; and are generally considered to be illiquid due to restrictive repurchase procedures. These investments may also involve different regulatory and reporting requirements, complex tax structures, and delays in distributing important tax information.