If you are a regular investor, you might have heard terms like value funds, value investing or momentum funds, momentum investing. All these types of investing come under the broad umbrella of factor investing.
Using a predetermined set of guidelines or parameters, factor investing is a technique for selecting stocks or other asset types. It refers to an investment strategy that uses "factors," or certain "characteristics," that cause stock returns to vary from one another. These elements include stock size, momentum, volatility etc.
Numerous mutual funds and exchange-traded funds (ETFs) are available that concentrate on different variables. For instance, if you want to invest in something with minimal volatility, look minimum volatility ETF.
All the factors are divided into two broad categories- Macroeconomic factors and style factors.
Macroeconomic factors are those that have no direct relationship to financial assets but nonetheless have an impact on their pricing. GDP growth, interest rates, inflation are some of the examples.
On the other hand, style factors are those that are directly connected to and reflect the risk and returns across asset classes. For example- value, quality, size, momentum, and other elements.
Advantages of factor investing
You have greater transparency with factor investing than with traditional investment. You might not understand the cause of subpar returns or subpar performance in traditional investment. However, if you've invested in a factor-based fund, you may quickly ascertain why the fund has performed as it has.
You may have observed that your entire portfolio is in the red when the market is down if you place all of your eggs in one basket. Factor investing comes in handy here. You get a well-diversified portfolio when you invest in a multi-factor fund where the components are less connected. As a result, while one component is ineffective, another one could, saving you from being a victim of a market decline.
Additionally, codifying the rules and locating appropriate opportunities are two aspects of factor investing. As a result, managing the portfolio doesn't involve much work from the fund management. Because of this, factor investing is less expensive than a conventional active investment approach.
However, factors do carry some risk, and failing to be aware of these risks might leave a trader underprepared. First and foremost, it is important to remember that sometimes a component may only be viewed in terms of the rewards it offers and not the mistakes it may bring about.