Factor investing explained: Value, momentum, quality and how smart beta strategies work
Editorial staff, J.P. Morgan Wealth Management
- Factor investing is a strategy that targets specific investment characteristics, or “factors,” that research shows have driven returns above the broad market over long periods of time.
- It may be worth considering factor investing if you’re a long-term investor who wants more precision than a passive index fund provides.
- One practical entry point for investors is a multi-factor fund or smart beta exchange-traded fund (ETF), which provides transparent, rules-based and cost-effective factor exposure while helping to diversify the risks associated with individual factor cycles.
Most investors are familiar with the idea of buying stocks or bonds. Fewer think about why certain investments tend to outperform others over time, or whether that pattern can be captured using a rules-based system. That's where factor investing can come in.
At its core, factor investing is a strategy for building a portfolio around specific asset characteristics, or "factors," that research has linked to higher long-term, risk-adjusted returns.
As with any investing strategy, returns are never guaranteed. But common traits among equity investments include stocks that are cheap relative to their fundamentals, stocks that are on a strong recent price trend and stocks that are financially stable.Ultimately, the goal is to earn returns that go beyond what the broad market may deliver – without relying on a portfolio manager's judgment call on any individual stock.
Factor investing:
Factor investing isn't new. The foundation for factor investing was laid in the 1960s with the development of the Capital Asset Pricing Model (CAPM). The strategy later matured into a multi-factor approach in the early 1990s with the groundbreaking work of Eugene Fama and Kenneth French.
As the name implies, factor investing tends to resonate with investors who are comfortable thinking in longer time horizons, who understand that any single factor can underperform for extended periods and who want to build a more intentional portfolio that can weather the market’s cyclical nature to help drive strong long-term results.
Factor investors tilt their allocations toward a handful of well-established categories. Common strategies, such as investing in cheap value stocks, trending momentum winners, fundamentally sound quality companies and low-volatility equities, capture different risk-versus-return profiles.
Today, factor-based strategies are available to everyday investors through mutual funds and ETFs, providing broad accessibility at a fraction of the historical cost.
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Key factors explained: Value, momentum and quality
Value stocks are companies trading at low prices relative to key fundamentals, like the price-to-earnings (P/E) ratio or price-to-book (P/B) ratio. Historically, value stocks have outperformed growth stocks over long periods. The trade-off is that value can lag significantly in bull markets driven by growth and momentum.
Investors who prefer to capture the positive performance of recent winners may find what they are looking for in momentum investing. Stocks that have performed well over the past six to 12 months have historically continued to outperform in the near term. Momentum strategies can generate strong returns in trending markets, but they're also prone to sharp reversals that can result from changes in sentiment or other structural factors.
Quality companies are characterized by stable earnings, strong balance sheets, high returns on equity and sound management. Investors might find that these companies aren't necessarily cheap, and they may not be trending higher, but they do tend to hold up in downturns and compound steadily over time.
If you’re compelled by the idea that these factors can be powerful on their own, they often perform best at different stages of the market cycle. By combining multiple factors into a single strategy, you can help smooth out individual volatility and reduce the risk of a deep drawdown when one specific style falls out of favor.
What are smart beta strategies?
In investing, beta measures a security's sensitivity or systematic risk relative to the broader market. Smart beta strategies use rules-based weighting methodologies to separate themselves from traditional market-capitalization weightings with the goal of obtaining better risk-adjusted returns.
Investors looking to focus on one factor may find single-factor funds to be effective. For example, a value ETF might screen for low P/B ratios across a universe of large-cap stocks.
Then, there are multi-factor funds that blend several factors, such as value, quality and low volatility. The aim here is to capture diverse return sources while smoothing out the periods when any one factor is out of favor.
The appeal of smart beta can include the following:
- Transparency: The rules are disclosed, so you know exactly what you own and why.
- Cost: Smart beta funds typically cost less than traditional active management because they use a systematic, rules-based approach rather than a higher-cost "human-driven" selection process.
- Systematic discipline: Rules-based strategies eliminate emotional panic and manual drift, helping ensure a disciplined allocation that ignores headlines.
Now that you understand some of the potential benefits of the smart beta approach, let’s consider some of the possible drawbacks:
- Cyclicality: Any single factor can underperform the broad market for years at a time.
- Drawdown potential: Smart beta funds aren't immune to market downturns, since they hold mean-reverting assets, meaning they tend to move back toward a long-term average.
- Style drift: If a fund changes its methodology, the factor exposure you thought you were getting can change without warning.
How to use factor and smart beta funds in a portfolio
For most investors, this approach to investing is best used as a strategic complement to a core passive allocation. In addition, it provides a disciplined way to target specific return drivers without the higher costs of traditional active management. Like other strategies, however, how you go about implementation matters.
When a portfolio is concentrated in a single factor – like pure momentum, for example – you run the risk of significant losses if the rest of the market moves in a direction that doesn't favor that strategy. Multi-factor strategies address this by blending exposure so the portfolio isn't entirely dependent on one theme being in favor.
Factor exposures drift over time as markets move and factors cycle in and out of favor. Therefore, setting a target allocation, reviewing it annually and rebalancing if needed can help keep the intended tilt intact without requiring constant trading.
Mutual funds and ETFs offer an effective way to participate in factor investing, but it’s important to choose those that offer clear rules and disclosures. Low-cost funds with transparent rules are good starting points, but the details determine whether the strategy delivers what it promises.
Things to keep in mind with factor investing
Before implementing a factor-based investment approach, there are a few common mistakes to be cautious of.
If a factor has outperformed for an extended period, that could be a sign that the investment is becoming crowded and positive returns could start to reverse. Factor investing rewards patience, not trend-chasing.
Next, a portfolio concentrated heavily toward one factor can look very different from the broad market during drawdown periods. This stands as another reminder to take the time to know what you own.
Then, there are the tax implications. Factor strategies that involve a large amount of investment turnover can generate significant short-term capital gains. In a taxable account, those gains erode net returns. So, don’t just consider pre-tax returns – look at the after-tax performance, too.
Lastly, methodology changes happen and must be monitored. If a fund redefines how it measures quality or changes its rebalancing frequency, the exposure you initially bought may no longer be what you're holding.
The bottom line
Factor investing is an investment approach that can complement passive indexing and traditional active management. It gives you a rules-based and relatively low-cost way to tilt your portfolio toward characteristics that have historically been rewarded. It requires patience, diversification across factors and understanding that no factor outperforms in every environment. Used properly, factor investing may help enhance returns, improve risk-adjusted performance and give you more control over how your portfolio is constructed. For more guidance on implementing factor investing, talk with a trusted financial professional.
Frequently asked questions about factor investing
There's no universal answer, but a practical starting point is to use a multi-factor fund as a single allocation rather than building separate single-factor positions. If you want more control, equal weighting across common factors like value, quality, momentum and low volatility is a reasonable baseline. Review your allocations annually and rebalance toward targets rather than chasing whichever factor has recently done best. And with a financial professional if you’re unsure of how to get started.
The primary risks are market cyclicality that can cause any factor to lag for long periods, methodology risk if a fund changes its rules, turnover and tax drag in higher-rebalancing strategies, and concentration risk in single-factor portfolios.
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Editorial staff, J.P. Morgan Wealth Management
