Factor based investing (FBI) refers to allocating to certain investment styles (or factors), with the main ones illustrated below. Such factors have historically generated excess returns over the long term, attributed to a combination of structural, behavioural and risk-based explanations. Also known as ‘smart beta’ or ‘alternative risk premia’, these different factors have informed the evolution of how we classify and attribute performance and risk in portfolios, particularly the balance between active managers’ skill (alpha) and broad market exposure (beta).
FBI is thus more than just a single index or fund: it is a way of investing that can be used for achieving specific investment objectives. Some of these objectives include the potential for:
- Return enhancement
- Risk reduction
- Income generation
The rising popularity of index-based investment strategies has been a clear feature of the institutional investment landscape in recent years. Comparatively low transaction costs, ongoing charges and governance costs are often cited by investors as advantages of using index funds.
Where does FBI fit in portfolios?
FBI can help investors understand the source of returns. Decades of academic research have shown that a number of common security characteristics or ‘factors’ have historically delivered improved returns relative to market-cap weighted indices over the long term, and FBI strategies allow investors to access these factors. As such, FBI can be viewed as a complement to active or index approaches when seeking specific objectives within a portfolio.
Evolution of alpha & beta
Source: LGIM, Zaher (2019), Index Fund Management: A Practical Guide to Smart Beta, Factor Investing and Risk Premia.
Because a specific factor’s returns can vary significantly from year to year, some clients also seek to build portfolios of different factors.
Annual factor performance
Source: LGIM, MSCI, FTSE-RAFI, all data for calendar year to 31 December. Past performance is not a guide to the future. The value of an investment and any income taken from it is not guaranteed and can go down as well as up; you may not get back the amount you originally invested.
The value of an investment and any income taken from it is not guaranteed and can go down as well as up, you may not get back the amount you originally invested.