Factor Investing
How factor strategies can work in a portfolio
Whether you’re looking for a specific outcome, long-term returns, or a way to express a market view, factors can help investors achieve their goals.
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 explain risk and return within asset classes such as equities, bonds and commodities. The most well understood and commonly used are equity factors.
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.
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.
Rolf Banz The Relationship between Return and Market Value of Common Stocks Journal of Financial Economics, 1981.
Narasimhan Jegadeesh and Sheridan Titman Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency Journal of Finance, 1993.
Robert Haugen and James Heins On the Evidence Supporting the Existence of Risk Premiums in the Capital Markets Wisconsin Working Paper, December 1972 and Robert Haugen and James Heins Risk and the Rate of Return on Financial Assets: Some Old Wine in New Bottles Journal of Financial and Quantitative Analysis, 1975.
Source: ‘Portfolio Defense and Low Bond Yields’, Invesco Global Asset Allocation Team (2020).