Factor investing, or smart beta, has become quite popular over the past several years. The gist of factor investing is that there are certain company specific variables, or factors, that explain the majority of differences in stock returns. Two now famous academics, Eugene Fama and Ken French, developed a factor model that identified company size (market capitalization) and value (cheap vs. expensive) as the key drivers of individual stocks that performed better than the overall index of stocks. They later added two additional factors, company profitability and an investment factor, which basically attempts to differentiate between companies that invest conservatively and aggressively. Other popular factors not included in Fama and French’s factor models include momentum and quality.
By identifying the factors that drive an individual stock or group of stocks to perform better than the broader universe, an investor could theoretically “beat the market” on a consistent basis. The challenge here is that different factors perform differently at different times and it’s really hard to know in advance when an individual factor will perform well or poorly. However, there is merit in factor investing and in my opinion should be a part of every investor’s portfolio as it offers diversification from an investment strategy perspective. As readers of this blog know, diversification is one of the major themes I discuss fairly regularly. It’s also something I emphasize with my clients in nearly every conversation and it is also something that I practice within my own investment portfolio. Factor investing provides a different type of return stream than say an S&P 500 index fund might. A good factor strategy will provide outperformance at times but will also underperform at times. The primary benefits of factor investing are the diversified return stream it offers as well as the potential for meaningful outperformance over time. Factor investing is something all investors should at least consider.