Fact Fiction and Factor Investing: A Guide to Choosing the Right Approach

Choosing the right investment approach can be overwhelming, especially with the abundance of information available. Research suggests that 70% of investors rely on emotions rather than facts when making investment decisions.

Understanding the difference between fact and fiction is crucial in making informed decisions. Fact-based investing focuses on evidence-driven strategies, such as value and momentum, which have been consistently proven to outperform the market.

Investors often get caught up in the hype surrounding factor investing, but it's essential to separate fact from fiction. A study found that 90% of investors who use factor-based strategies do so without a clear understanding of their underlying mechanics.

By taking a fact-based approach, investors can make more informed decisions and avoid costly mistakes.

Additional reading: Investment Decisions

Investors can use factor ETFs to seek outperformance by targeting specific factors like value or momentum.

Factor ETFs can be used to manage risk in a portfolio by offsetting an overweight to growth with a value ETF, for example.

Investors can also use factor ETFs to express a short-term view on markets, such as using a minimum volatility ETF to manage risk during a recession.

A single vehicle that combines factor exposures can be used to form the core of a portfolio, offering cost-effective and operational benefits.

Here are some key benefits of multifactor ETFs:

Value investing is a well-known factor that involves identifying undervalued stocks and holding them until the market adjusts its outlook. This strategy is based on the idea that the market often overreacts and undervalues stocks when their fundamentals weaken.

The opportunity to capitalize on value arises from the fact that the market tends to overreact and undervalue stocks significantly relative to their current earnings. A systematic quantitative value factor investing strategy can help you purchase these undervalued stocks and maintain the position until the market adjusts.

Value can be assessed using various metrics, including the P/E ratio, P/B ratio, P/S ratio, and dividend yield. These metrics help identify stocks that are trading at a discount to their intrinsic value.

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Factors are drivers of returns, and research has proven that value is a historically enduring driver of return. This means that value investing can provide consistent returns over the long-term.

Factors are economically intuitive, meaning that they tend to outperform at different parts of the economic cycle. For example, during economic downturns, value stocks tend to outperform growth stocks.

Factors offer differentiated returns and diversification benefits, with low correlations between different factors. This means that adding value to your portfolio can help reduce risk and increase returns.

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Low-volatility investing is a strategy that involves acquiring stocks or securities with low volatility while avoiding those with high volatility.

The low-volatility anomaly was identified in the early 1970s, but it gained popularity after the 2008 global financial crisis.

Different studies demonstrate the effectiveness of this strategy over extended periods, making it a popular choice among investors.

Low-volatility tends to reduce losses in bear markets, which can be a significant advantage for investors looking to minimize their losses during downturns.

The low-volatility anomaly is not incorporated into the Fama-French five-factor model, which is a widely used framework for evaluating investment strategies.

A full business cycle is necessary to comprehensively evaluate the effectiveness of low-volatility investing, as it often lags during bull markets.

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Factors are broad, persistent drivers of return that research has proven to be historically enduring. They can be used to seek outperformance or manage risk in a portfolio.

Momentum investing involves buying stocks or securities with high returns over the past three to twelve months and selling those with poor returns over the same period. This phenomenon is not fully explained by the efficient market hypothesis or random walk hypothesis.

Some factors are rewarded for bearing higher risk, such as small cap companies that have historically been more volatile than their larger peers. This can lead to a persistent underweight to less volatile companies.

Investors have traditionally used factor ETFs in three main ways: seeking outperformance, managing risk in a portfolio, and expressing a short-term view on markets. For example, an investor working at a large technology company may look to add a value ETF to help offset the overweight to growth they currently have from their company's stock.

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A single vehicle that combines factor exposures can be used to form the core for your portfolio. These types of "multifactor" strategies often seek exposure to factors that have historically outperformed the broad market while also maintaining a similar level of market risk.

Here are some key takeaways about factors and factor ETFs:

Index funds provide broad diversification by tracking a specific market index, such as the S&P 500. This can be a low-cost way to invest in the market.

Actively managed funds, on the other hand, are run by human managers who try to beat the market by making individual stock picks. However, these funds often come with higher fees.

Dividend investing can be a smart strategy for income-seeking investors, as it provides a relatively stable source of returns.

BlackRock has been at the forefront of factor-based investing for decades, making them a trusted choice for investors.

Their deep experience with factor investing is evident in the variety of ways they offer to implement this strategy, ranging from Factor ETFs to multi-factor strategies.

BlackRock's low-cost, efficient access to factors makes them a great option for those looking to tap into the persistent drivers of return.

You can tap into their expertise via insights provided by their Head of Factors Investing Strategies, Andrew Ang, or by browsing their online resources and tools.

When choosing an investment option, it's essential to consider your risk tolerance and financial goals.

Stock options can provide a high potential for returns, but they also come with a higher level of risk, as seen in the example of Amazon's stock price fluctuation.

Dividend-paying stocks offer a relatively stable source of income, with companies like Coca-Cola and Procter & Gamble consistently paying out dividends.

Index funds track a specific market index, such as the S&P 500, and offer broad diversification, making them a low-risk option for investors.

Real estate investment trusts (REITs) allow individuals to invest in real estate without directly managing properties, providing a steady income stream and potential long-term growth.

Peer-to-peer lending platforms enable investors to lend money to individuals or small businesses, offering a relatively low-risk option with potential for regular income.

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There are two main types of factors that drive returns: macro economic factors and style factors. Macro economic factors capture broad risks that exist across asset classes.

These factors help to explain broad market risks, such as economic downturns or inflation. They're like a safety net for your investments, helping to mitigate potential losses.

Style factors, on the other hand, explain risks and returns within specific asset classes. They help to identify specific characteristics that contribute to an asset's performance, such as its value or momentum.

A unique perspective: Investment Style