Weaved throughout every investment you make, factors are the underlying characteristics that drive investment performance. Factors aren't a recent development but what is new is how we evaluate the effects of factors on a portfolio and their risk and returns.
Factor based investing is a form of active management
Regardless of whether factor-based investment products get their factor exposure by following a published index or through the decisions of an active manager, it’s important to understand that factor- based investing is an active management strategy because it involves making a decision to tilt a portfolio away from traditional market-capitalization weightings. As a result, with factor-based investing, you should expect a different risk and return profile than that
of the broad market.
Enjoy transparency and control
Historically, investors have targeted factors in one of two ways—through traditional active funds and through style index funds and ETFs. More recently, factor-based funds and ETFs offer a third option. The advantages of this approach include greater transparency, more control over investment exposure, and lower cost than a traditional active approach.
Investors often have a range of factor exposures in their portfolios, whether explicitly through very deliberate decisions or implicitly because of an investment process.
By deliberately focusing on factor exposures as part of the portfolio construction process, investors know what they own and get a clearer view of the potential drivers of portfolio returns. Factor-based investing is also a practical option for those looking to have significant control over their portfolios’ factor exposures.
In fact, with factor-based investing, you and your advisor can choose to target the exposure of a single factor or employ a multifactor strategy that harnesses the diversification benefits of multiple factors.
Patience is the key
It’s important to stress that while factor-based investing can be a lower-cost, more transparent alternative to traditional active investing, it requires you to be patient and stay the course during periods of underperformance.
Work closely with a financial advisor who understands the advantages of factor-based investments and how they may be implemented in your portfolio.
Understand the risks
Historically, factor-based investments have experienced sustained periods of underperformance. In addition, factor-timing is extremely difficult. Strategies that attempt to time factor returns are ill-advised and investors should consider factor investing a long-term strategy.
To help maintain a commitment to factor investing it is probably helpful to build a more diverse portfolio of factor exposures. This should increase the likelihood that you will have the discipline to stick with that diverse basket of multi-factors through different market cycles.
Another important aspect to consider is that factor-based funds and ETFs aren’t designed to be tax efficient. Depending on your tax situation, you may want to own them in retirement accounts.
Making the factor-based investing decision
Factor-based investing represents a dynamic tool designed to help you achieve specific investment goals. Direct targeting of factors through factor- based mutual funds and ETFs may offer the many benefits of traditional active mutual fund investing but at a lower cost and with less manager risk.
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