Factor investing is an investment style that forgoes traditional analysis of individual companies and stocks in favour of a systematic selection of securities with shared characteristics – factors – that historically have proven to be persistent drivers of above-market returns.
In general, a factor is any characteristic that can explain the risk and return of groups of securities. There are two main categories: style factors such as value and momentum drive returns within asset classes, while macroeconomic factors such as credit and inflation can be used to explain risk and returns across asset classes. Factor investors incorporate so-called ‘factor exposures’ into their portfolios by identifying which securities provide exposure to which factors.
Factors have a long history in academic literature. The Fama-French model (1992) successfully demonstrated that US equity market returns can be explained by the market, size and value factors, and is perhaps the best-known academic work on the subject.
Factors tend to exhibit low correlations with each other, so they have become popular as a means of diversifying portfolios since the financial crisis. Instead of investing across asset classes to provide diversification – which can be painful in times of crisis if markets are correlated – investors can use factor investing to target non-correlated, persistent drivers of returns.
In the past, factor investing has been the exclusive domain of active managers and quantitative hedge funds, but advancements in computational analysis and data processing, combined with investor appetite for higher returns at lower costs, mean many non-quantitative and retail traders have now embraced factor investing as well, leading to concerns about crowding.
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