Not Active, Not Passive: An Intro to Factor Investing
Active investing tries to beat the market by trying to buy the winners and avoid the losers.
Passive investing tries to match the market by buying everything.
Many investors are familiar with these two broad types of investing strategies. But there’s actually a third way that walks the middle road between the two: factor investing.
Factor investing is a strategy where you invest based on certain characteristics. It lets investors be a bit more active in their portfolios than a purely passive strategy by using data and evidence to guide their decisions.
Since factor investing is new to many people, I did an overview of it on episode 57 of The Canadian Money Roadmap podcast. You can listen to the full conversation or keep reading for the high-level notes you need to know about.
What is Factor Investing?
The short answer is that it’s an investment strategy based on specific factors, or characteristics, present in a stock or group of stocks. Factors are things like size or dividend yield—more on the different types of factors below.
The longer answer starts with learning a bit of Greek. When we talk about market returns, we use the Greek letter beta (ꞵ) to refer to the risk level and returns of the market. In practice:
A passive investing strategy has a goal of hitting the beta, or meeting the market average. Investors do this by buying securities that represent the entire stock market and hold for the long term.
An active investing strategy has a goal of beating the beta and achieving alpha (𝛼) by attempting to invest in the best performing stocks over time.
Active investing is typically done by portfolio and investment managers, who can charge a premium fee to manage your investments. It’s also very difficult to actually outperform the market and reach alpha.
Factor investing, then, offers a third option. There’s a lot of research and evidence to suggest that factor investing can be an effective strategy to achieve higher returns or minimize risk. For this reason, it’s often called “smart beta.”
Another term for factor investing is “rules-based investing.” Most investing is done digitally, so the algorithm that picks stocks and securities for a mutual fund or ETF has the “rule” to only invest in those with specific factors.
6 Factors to Know About
Factor investing, when done correctly, can increase expected future returns or reduce risk. But the key here, as with any investment strategy, is that you need to build your portfolio in line with your investment goals, timeline, and risk tolerance.
For that reason, I’m not suggesting any specific factors to anyone. This is a good topic to discuss with your financial planner or other professional to see what’s right with you.
All that said, there are some factors that are most prevalent today. Here are the six factors you should be aware of:
Dividend Yield
This factor is specific to dividend-paying companies. Dividends are the distribution of earnings from a company to its shareholders.
This factor, then, is seeking higher-than-average dividend yields. Note that it’s not the highest yield, but higher than average.
2. Low Volatility
Conservative investors may be interested in this factor. Low volatility targets stocks with lower risk than the broader market. This might include companies with stable earnings and cash flow over time, likely older and more established companies.
Note that this factor hasn’t been shown to increase returns, but it can allow for market-like returns (beta, remember?) with less volatility.
3. Quality
I know what you’re thinking—shouldn’t all my investments be quality? But this factor has a specific definition: a company with a quality factor is more profitable, has low debt, gets good borrowing rates, and has strong cash flows.
It’s easiest to understand with a comparison. Tesla is a trendy, popular company. But, because of its rapid growth and innovation, it’s more volatile and has unpredictable cash flows and profits. Therefore, it’s not representative of a quality-factor company.
Compare this to Apple, which has been around for a long time. They have an established market share and have strong profits and cash flows. They currently represent a quality-factor company.
4. Momentum
This next factor refers to stocks that are outperforming the market in the short-to-medium term. To invest in momentum stocks, you’re likely buying and selling at a fairly rapid pace. This is because the stock market is always changing, always moving based on what’s going on in the economy and companies.
So, momentum takes advantage of price trends—what’s doing well now. Of all the factors, it may be the most challenging to replicate on a regular basis.
5. Value
Similar to quality, you’re probably thinking you always want stocks with value! In this context, value looks for lower-cost stocks that are undervalued relative to their intrinsic value.
So, if you think a stock of ABC Company should be $20.00 per share, but is currently valued at only $15.00, it’s undervalued. Value stocks are the underdogs of the market—not quite getting the recognition they deserve until they outperform the rest.
6. Size
The last factor to note is based on the size of the company. Specifically, size factor is concerned with small companies that outperform large companies over time.
Think of it like this: a new company can only grow as time goes on, whereas an established company has a harder time growing. With their growth potential, small companies may be able to outperform larger companies over time.
That said, not all small companies outperform larger ones—it’s small, profitable companies that do. This pairs multiple factors together to indicate overall performance.
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These six factors are common characteristics that investors look at. They can be combined together, or you can cycle through them as the market ebbs and flows.
The important thing to remember—as with anything about investing—is that this strategy is only effective if it aligns with your investment goals and objectives. So, listen to the podcast episode to learn more, and then connect with your financial advisor to discuss your own personal investment strategy.
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Evan Neufeld is a CERTIFIED FINANCIAL PLANNER® professional in Saskatoon, Saskatchewan and offers both investing and fee-only financial planning services.
*Disclaimer: Any numbers or rates of returns are used for illustration purposes only and should not be taken as fact. Note that the information in this article is current to the time of writing but is not guaranteed as up-to-date past then.
This article and accompanying podcast do not constitute personal financial advice. Evan Neufeld is a CERTIFIED FINANCIAL PLANNER professional in Saskatoon, Saskatchewan, and provides this Canadian personal finance content for educational purposes to the public. You are welcome to contact Evan to receive personalized fee-only financial planning or investment portfolio management.