What is Factor Investing? 3 Factor Investing ETFs to Watch!
In this article, we answer the question ‘what is factor investing?’ and the different factors to consider when using this type of investment methodology. This article will also cover how to use factor investing ETFs (exchange-traded funds) to build a diversified portfolio of factor investments.
Table of Contents
What is Factor Investing?
Factor investing is the methodology of identifying stocks based on predetermined factors that act as the drivers of return. The two main types of factors include macroeconomic and style factors. Nowadays, there is an extensive range of ETFs (exchange-traded funds) that focus on investing in these specific factors.
Finding individual investments using macroeconomic techniques is less common as these factors can be too broad and more suited to risk managing a portfolio. Macroeconomic factors include business cycles, interest rates, inflation, credit risk, political risk and liquidity risk.
Identifying investments using style factors has become increasingly popular with many investment managers setting up funds to focus on a style. Factor investments based on style include analysing value, volatility, momentum, quality and size.
5 Factor Investing Styles
Over the past several decades, financial market researchers have come up with a range of factors that can lead to a stock’s outperformance. Five of these styles are listed below.
Value investing has been made famous by Warren Buffett and his teacher Benjamin Graham. The idea is that – over the long term – undervalued stocks could present better growth potential than overvalued stocks.
Value stocks can be identified using financial metrics such as the price-to-earnings ratio, price-to-book ratios and others. Undervalued shares should not be mixed up with cheap shares. The key is to find high-quality companies that are trading at a discount.
The volatility of a stock is measured using ‘beta.’ This is a financial metric that compares a stock’s volatility to the market’s volatility. If a stock had a beta of 2.0 and the overall market rose 10%, then the stock would likely go up 20% and vice-versa to the downside.
Low volatility stocks are considered to be more stable and can sometimes perform better than high volatility stocks during a bear market. By investing in stocks which are regarded to be more stable, investors can build a portfolio that can be managed during bull and bear markets.
Using momentum to identify stocks that could outperform is also known as trend following. Investors can calculate momentum by identifying the returns over a fixed period of time in the past (the last few weeks, months, quarters or years) and then choose the top quarter of stocks which produced the highest return.
While this tends to be a popular method for more active traders it has less to do with company fundamentals and more to do with herd mentality. A stock that outperforms can attract more investors who want to capitalise on price rises creating a flurry of buying that can diverge from company fundamentals.
Using momentum as a style to invest in carries far more risk than other styles as small negative news or earnings announcement can cause short-term investors to exit the market leading to a more aggressive sell-off and unwinding of positions.
Using quality as a metric in identifying stocks that could outperform has a different meaning for each investor. The measurement of quality can vary and include earnings price growth, low debt, high-quality products, etc. The concept is to invest in companies that are financially healthy.
There is a large range of quality-based factor ETFs in which the prospectus will define how the fund manager determines quality.
The size of a company matters to the long-term performance of an investment. Smaller companies can offer the potential of higher returns in the long term as there is more room for them to grow. However, there is also the risk a smaller company never turns into a big company and produces a poor stock price performance.
There are many exchange-traded funds (ETFs) that use size to determine factor investments. These are often in the title of the fund such as ‘small-cap stocks’ or ‘large-cap stocks.’ While small-cap stocks have the potential to grow more than large-cap stocks, they are considered to be riskier and may not be suitable for all investors.
How to Choose the Right Factor Investments
Identifying which factor is the best to use is very challenging. Professional investors who do it for a living, often get it wrong. This is why many investors choose a combination of factor investing and smart beta strategies.
By using smart beta strategies investors aim to diversify their investments into a variety of different factors. Diversification is an essential tool for risk management and making sure an investor does not put all their eggs in one basket.
It can also be challenging for retail investors to identify the best stocks within each factor style. One option is to use factor investing ETFs instead. This is where the fund manager will invest in a basket of stocks that focuses on a one-factor style, allowing an investor to gain access to a broad range of factor investments.
3 Factor Investing ETFs to Watch
There is a large range of ETFs that cover different themes and factors. Below is a list of just three ETFs that focus on certain styles within factor investing.
1. iShares Edge MSCI USA Momentum Factor ETF
The iShares Edge MSCI USA Momentum Factor ETF invests in US large and mid-cap stocks that exhibit high price momentum. The top five holdings in the fund - at the time of writing - include Apple, Exxon Mobil, UnitedHealth Group, Chevron and Procter & Gamble.
With Admirals, you can trade the iShares Edge MSCI USA Momentum ETF CFD. CFDs (contracts for difference) allow investors to speculate on the ETF’s price direction and potentially profit from both rising and falling prices.
2. iShares Edge MSCI USA Value Factor ETF
The iShares Edge MSCI USA Value Factor ETF invests in stocks with low valuations based on fundamentals. The top five holdings in the fund – at the time of writing – include AT&T, Intel, Cisco Systems, Ford and Pfizer.
From the Admirals Trade.MT5 account, you can trade the iShares Edge MSCI USA Value Factor ETF CFD with a competitive commission of just $0.02 per share and a low minimum transaction fee of just $1.
3. iShares Edge MSCI Min Vol Global ETF
The iShares Edge MSCI Min Vol Global ETF CFD tracks the performance of the underlying ETF which invests in stocks that have lower volatility characteristics compared to the broader market. At the time of writing, the top five holdings in the fund include Waste Management, Johnson & Johnson, Roche Holding, Nestle and Verizon Communications.
How to Trade Factor Investments
To start trading factor-based stocks or ETFs, you will need to open a trading. Admirals provide a range of live and demo trading accounts which provide access to stocks and ETFs from 15 of the world’s largest stock exchanges.
Below is a four-step process on how to trade factor investments using the MetaTrader 5 web platform provided by Admirals.
- Login to Admirals to access the Trader’s Room.
- Next to the account you want to trade from, click the Trade icon.
- From the bottom of the MarketWatch window, type the name of the stock or ETF you want to trade on and then drag the name onto the chart to view its live price.
- Open a trading ticket by clicking on New Order at the top of the window which will allow you to input your trade size, entry, stop loss and take profit levels.
Source: Admirals MetaTrader 5 Web, 21 August 2022
Why Start Factor Investing with Admirals?
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Frequently Asked Questions on Factor Investing
What is factor investing?
Factor investing is the methodology of identifying stocks based on macroeconomic or style factors such as value, size, quality, momentum and volatility.
Why use factor investing?
Investors use factor investing to try and identify stocks that will outperform the broader market. However, having a concentrated portfolio can add more risk to a portfolio so diversification across different factors is key.
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