The Five Factors of Smart Beta Investing

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By Dave Gedeon / Head of Research & Development, Nasdaq Global Indexes

Although recent interest in factor-based investing would lead one to believe that this is a new-fangled trend, the truth is factor-based investing has existed for decades. In fact, it has been a key component in the stock selection framework of active managers for years. At its core, factor-based investing involves identifying characteristics in a group of securities that help explain its risk/return profile. For example, value investing is a factor-based strategy that focuses on a subset of stocks that displays attractive valuation metrics relative to the general market. Thanks to smart beta, investors today can gain exposure to this factor and a wide array of others with ease, in a transparent and low cost vehicle.

These well-known investment factors have become the guiding philosophy behind a large swath of smart beta products. Third party research1 indicates that these factors deliver results with returns in excess of market capitalization strategies over the long run. Each individual factor may not outperform every year, but over time the factors can provide a superior risk/return profile to the broad market. Moreover, factor strategies tend to display low correlation with each other as each is driven by a different set of risk factors.

Related: Indexers See Further Growth for Smart-Beta ETF Strategies

There are many factors at an investor’s disposal, and the explanations of investment returns are limitless. The five factors of focus in this piece are Volatility, Momentum, Quality, Size and Value. Perhaps more important than the explanation of the factors is an investor’s ability to select a factor that is favorable in certain market environments or even to combine several factors into a single portfolio.

Low volatility. The concept of low volatility or low beta is simple yet powerful. A portfolio comprised of stocks with lower volatility when compared to its benchmark can produce higher risk-adjusted returns and generally produce a superior information ratio over all periods. This factor becomes increasingly potent in times of market strife such as witnessed in 2008.