What is factor investing?

We describe factor investing as the third pillar of investing alongside traditional active and passive approaches. Factors are the building blocks that contribute to the risk and return of a financial asset. In turn, factor investing selects investments for portfolios based on their relationship with these building blocks, or factors.

These factors have been identified following the analysis of years of historic market data. And, the most useful factors are those that consistently explain risk and return patterns across markets and through time.

A bit like the investing equivalent to DNA, these factors play a part in all portfolios, whether or not a factor approach is used.

Factors can be used in portfolio analysis to reveal relevant and actionable information – so, if a portfolio is unintentionally tilted towards a specific factor this can be corrected. At Invesco, we believe factor investing has the potential to drive outperformance, supporting a better risk-adjusted trade-off within a truly diversified portfolio.

Style factors – building the foundation of your portfolio

Style factors explain risk and return within asset classes such as equities, bonds and commodities. The most well understood and commonly used are equity factors.

• Size. Seeks to capture the growth potential of smaller firms relative to their larger counterparts. It's not always a case of bigger is better – often quite the opposite. Small companies have been found in the past to produce higher returns ¹.
• Quality. This is defined by indications that show stable earnings, low debt and strong governance. Investors can spot a high-quality stock by looking at financial metrics such as debt to equity and return to equity.
• Value. Aims to capture excess returns from stocks that have low prices relative to their fundamental value, based on measures like earnings or cash flow.
• Momentum. Stocks that have outperformed in the past tend to perform well in the future ². This is what the momentum factor seeks to identify and capture.
• Volatility. Research has shown that low volatility stocks have outperformed those with high volatility over the long term, taking into account the associated risk for the same period ³.
• Dividend yield. Seeks to reflect the potentially higher returns of stocks with higher than average dividend yields. We know that over time dividend payments are an important element of total returns.

Factor investing is an extension of traditional asset allocation, which enables holistic and precise portfolio positioning. The relationship between security returns and the macroeconomic environment can help guide portfolio allocation decisions by associating various asset classes and investment strategies with their most pertinent macroeconomic factors.

This macro-factor framework may prove particularly relevant in the current investment environment, especially if we see a break in the long-standing investment trends of falling interest rates, low inflation and accommodative monetary policy.

For instance, high quality sovereign bonds have helped offset equity declines for many years. However, with yields close to zero, there is less potential for bonds to have this offsetting effect.

Indeed, in recent years, it has been shown that bonds have not appreciated sufficiently to offset equity losses like they did during the global financial crisis⁴. Whether this relationship holds or not over the next few years, factor analysis can help plan for and position a portfolio for many possible market events.

What explains the popularity of factor investing?

The build-up of a substantial body of academic research, coupled with advances in data collection and processing, has expanded investors’ understanding of the key factors that have historically contributed to risk and return.

This, together with an increase in the availability of factor-based products has set the stage for a growing interest in factor investing.

Our own research has tracked the rapid expansion of factor investing over the last five years. It has identified themes in investor experiences, barriers and implementation methods across institutional and wholesale investors.

We see that investors are looking for increased transparency, cost effectiveness, control and scalability in delivering on their risk, return and sustainable objectives. We believe the precise and systematic solutions that  factor investing can offer will continue to rise in popularity as they help meet these goals.