Foundational concepts for understanding

factor investing

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Key points:
• Factor investing is an investment strategy in which securities are chosen based on certain
characteristics with the goal of achieving a given investment outcome or to improve
long-term risk and return.
• Factor investing is based on rigorously studied investment factors — characteristic, quantifiable
features of an asset that can be cost-effectively targeted in a diversified portfolio.
• Once understood, factor investing stands as a third pillar of investing, complementary to
traditional alpha sources and market-weighted indexing with its own use cases, strengths and
Blaise Warren weaknesses.
Chief Operating Officer –
Global Factor Investing, Invesco

Today, factor investing has established itself as

a third pillar of investing, offering investors a
complementary approach to traditional active
and pure passive investing.
Stephen Quance
Global Director - Factor Investing, Factor investing has a well-established and increasingly important role in investors’ portfolios.
Invesco
Over 70% of institutional investors surveyed in 2018 were using factor strategies and more than
60% were planning to increase their use of them in the following years, according to the Invesco
Global Factor Investing Study, which was carried out by NMG Consulting. Increasingly, however,
factor-based investing has also become important for private investors and their advisers.

A growing number of investors are seeking a better understanding of the elements that drive
returns and reduce risk. Factors can help investors gain this understanding and thus offer better
control and transparency. Today, factor investing has established itself as a third pillar of
investing, offering investors a complementary approach to traditional active and pure passive
investing.

In this paper, you will learn what factors are and what role they can play in a portfolio.
 Factors as important indicators of risk and return

There are several reasons why factor investing has gained so much importance recently. First,
Insight: What is factor investing?
exciting advancements in the study of asset pricing, largely from academia, have shown the huge
Factor investing identifies
potential for factor-based strategies to play a major role in diversified portfolios. Second, factor
characteristics of securities that can
analysis frequently helps explain portfolio behavior in ways that were previously not well understood;
be targeted with investable securities
even for portfolios that do not utilize a factor approach. Factors help explain risk and return,
and structuring portfolios to either
allowing greater granularity, control and customization. This transition is supported by decades
capture or avoid specific factors in a
of empirical research and is likely a permanent advancement in how assets are managed.
systematic way. A common objective
of factor investing within a rules-
As explained earlier, factor investing consists in selecting securities based on certain attributes.
based framework is to position the
But what attributes are we referring to? Factor investors focus on features of securities containing
portfolio in an attempt to outperform
material information about their risk and return. There are two major categories: macro factors
the market. In addition, factor-based
and style factors.
investing can contribute to portfolio
diversification or as a risk control
The macro factors are well-known and intuitive. They relate to the influence that factors such
mechanism. Finally, factor strategies
as economic growth and inflation rates have on security prices. Consider inflation for example.
are used as a cost efficient way to
Inflation broadly impacts financial and economic environments. Changes in expected inflation
lower overall portfolio costs. Due to
impact prices across stocks, bonds, commodities; just about any asset class. Many markets have
the explanatory power of investment
options to invest directly in inflation factor strategies such as TIPS or linkers.
factors, factor investing is becoming
a strategic, long-term element of
Recent focus in research and development has increasingly shifted toward style factors. Therefore,
many asset allocations. However, it
when someone talks about factor investing today, they are often referring to style factors, rather
can also be used in a tactical way.
than macroeconomic factors. For this reason, the bulk of the following discussion is focused on
Factor investing is currently receiving
style factors.
much attention, but the approach
as such isn’t new — its roots can be
traced as far back as the 1930s. In
the equity area, the most well-known
Figure 1
style factors include value, size,
Examples of style and macro factors
momentum, volatility and quality.
Style factors: Investment factors that can be expressed in investment strategies
The term “factor” is sometimes used
to refer to just about any piece of
data, but when Invesco talks about
factor investing we mean something
specific. An investment factor is one
we can pursue in a live portfolio
based on directly observable Value Size Momentum Volatility Quality Dividend Other
characteristics of securities with large yield investment
scale of assets, to achieve an factors
investment outcome. An investment (equity
factor should have a theoretical market,
rationale and empirical support, that liquidity,
is scalable and expressible using carry, term/
tradeable securities. Investment duration)
factors should be persistent,
pervasive, robust and distinct. Macro factors: Broad and systematic factors that impact asset prices but may not be
expressible directly using securities

Growth Inflation Financial

conditions

(Interest
rates,
currencies)

Source: Invesco. Illustrative examples of macro and style factors.

Foundational concepts for understanding factor investing 2

 Value, size and volatility

Value
Insight: Equity style factors
With value strategies, the emphasis is placed on securities that are priced at a discount to other
Value, size, volatility, quality, and
similar securities. The underlying assumption is that, over the long term, purchasing securities at
momentum are among the most
lower prices will lead to higher returns. But how do you determine value? As it turns out, there are
established factor strategies in equity
many different approaches that yield similar results. The index provider MSCI, for example, uses
investing. The objective of the value
dividend yield, price-to-earnings ratio (P/E ratio) and price-to-book ratio (P/B ratio) as criteria.
strategy is to identify securities that
Cash flows and net profit are sometimes used as criteria as well. Price-to-book — as well as size
are priced at a discount by some
— was used in 1992 by the scholars Eugene Fama and Kenneth French to expand the capital asset
measure. Size strategies focus on the
pricing model to produce the Fama-French three-factor model.1 In the fixed income context, value
shares of small companies, while
strategies can measure yield relative to credit rating by industry. However, there are also points of
low-volatility strategies emphasize
criticism. Quite apart from the fact that value strategies aren’t successful in all market phases,
securities whose prices fluctuate less
there is the considerable concern that innovative companies that don’t pay dividends and have a
than those of other securities.
high price-to-book value are excluded. For this reason, Invesco often prefers cash flow yield as a
Momentum strategies involve the
measure of value in equities.
purchase of equities that have
recently recorded an above-average
performance, while quality strategies Size
search for companies of superior With size (i. e. small cap) strategies, the focus is on the shares of small companies in the
quality. The distinction is made on expectation that they will outperform those of large companies. This relationship was first
the basis of quantifiable metrics such demonstrated in a study by Rolf W. Banz in 1981.2 Subsequent studies confirmed these results.
as a price-to-earnings and price-to- There are several explanations for the size factor. On the one hand, it is claimed that small
book ratio, dividend yield or volatility. companies have better growth prospects than large established companies. On the other hand,
While some criteria are generally analysts focus less on these companies, which therefore tend to be overlooked. It is also said that
recognized, the approaches can vary the shares of small companies are not as liquid as those of their larger counterparts, with
in other aspects. In all cases, investors preferring the shares of large companies. In some markets, the consistency and
however, it is a systematic, rules- magnitude of the size factor is tenuous, but it is often observed that other investment factors
based process. seem to work quite well across smaller companies, which increases its usefulness.

Volatility
The volatility factor (also known as minimum volatility or minimum variance) implies that shares
associated with lower volatility perform better on a risk-adjusted basis than those with higher
volatility. The observation was first described in 1972 by Robert Haugen and A. James Heins.3
Later studies also found that low-volatility shares outperformed those with high volatility over the
long term on a risk-adjusted basis. What might be the rationale to explain this unexpected
phenomenon? One possibility is a difference between reality and the realm of academic research.
Given a set of assumptions, theory says investors should be indifferent between low and high
volatility stocks because of access to leverage. In reality, investors may not be able to access
leverage, or the costs of leverage might be higher than assumed in the research. This practical
reality could cause investors to be willing to accept less incremental return as volatility increases.
On the other hand, the approach is criticized for its poor sector coverage, with low volatility
healthcare stocks overrepresented, for example. One note about the low-volatility factor: The most
rigorous studies of this phenomenon find results are largely driven by poor returns of highly
volatile securities. This result has important implications when considering a low-volatility
investment, but details of this finding are beyond the scope of this introduction.

Foundational concepts for understanding factor investing 3

Momentum and quality

Momentum
Within the framework of momentum strategies, the most known factor is price momentum.
Securities are purchased if they have performed well recently, and sold if they have performed
badly. The outperformers of the recent past are therefore seen as the outperformers of the
future.5 This factor was “discovered” by Jegadeesh and Titman in 1993.4 Momentum strategies
are usually justified by the findings of behavioral finance, which focuses on known modes of
behavior, such as the herd mentality, or anchoring bias for example. More recent studies find that
earnings momentum largely subsumes price momentum. Earnings momentum is commonly
defined as the trend in earnings surprises or changes in earnings expectations. The rationale for
earnings momentum is similar to price momentum, although the finding impacts how the factor
is captured in portfolios. Recent research suggests that the momentum factor also persists for
bonds, measured by return over a recent period of time.

Quality
The quality factor entails a focus on the shares of high-quality companies because they tend to
outperform those of lesser quality. Robert Noxy-Marx demonstrated in 20126 that the shares
of highly profitable companies achieve better risk-adjusted performance than less profitable
companies. Other criteria that are used to define quality include cash flows and debt ratios, as well
as the quality of the management and business model, along with the market environment, and,
with fixed income, a high credit rating, low duration, and low historical volatility. However, it is
problematic that some elements of quality often can’t be measured, such as the value of a brand
or good reputation. Not least, there is the danger that young high-growth companies — which don’t
yet have steady earnings — are excluded, as are companies that are highly sensitive to economic
trends.

Figure 2
Key systematic style factors

Seeks to capture Commonly captured by

Value Excess returns to securities that P/B, P/E ratio, cash flow yield,
have low prices relative to peers duration hedged yield in bonds
with higher prices in the long run

Size Excess return of smaller firms (by Market capitalization (full or

market cap) or issues in bonds free float) for equity and issue size
relative to their larger in bonds
counterparts

Momentum Excess returns to securities with Relative returns (6-mth,

stronger past performance 12-mth, usually with last
1-mth excluded), earnings revisions

Volatility Excess risk-adjusted returns to Standard deviation (1-yr, 2-yrs,

securities with lower than 3-yrs), downside standard deviation,
average volatility or beta standard deviation
of idiosyncratic returns, beta

Quality Excess returns to stocks that are Return on equity, earnings stability,
characterized by low debt, stable dividend growth stability, strength of
earnings growth, profitability, and balance sheet, financial leverage or
other “quality” metrics for bonds short duration, high credit
quality or low volatility

Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 4

 Factor investments: At times perform better than
the market

Insight: The crucial issue of Professional investors’ special interest in investment factors becomes understandable if the
returns on factor-based equity portfolios are considered and compared with general market
weighting according to market
capitalization developments. Indeed, factor investing has at times outperformed the market in the long term.
For global equity investments, the
data on the right show that factor
investments based on the style
factors of value, size, volatility, Figure 3
quality and momentum have Factor strategies — Historical index data shows outperformance potential
generally outperformed the MSCI Value Momentum Quality
World Index. In traditional indices, Size Volatility MSCI World
individual equities are allocated
to the index portfolio proportional 12/97 6/99 6/01 6/03 6/05 6/07 6/09 6/11 6/13 6/15 6/17 6/19
to their market capitalization. %
This means that — in the MSCI World
Index, for example — equities that 700
tend to have high valuations receive
a higher weighting than equities with 600
a low valuation. Cap-weighted indices
therefore tend to overweight
securities whose prices are high 500
relative to their financial
characteristics and to underweight 400
those whose prices have fallen.
Cap-weighted indices also can be
somewhat dominated by large 300
companies, with less exposure to
mid-sized and smaller companies 200
compared to a typical factor-based
approach.
100

Source: Invesco, MSCI from Dec. 31, 1997 to June 30, 2019 (total return, in USD). For illustrative purposes only. Indices:
Size = MSCI World Equal Weighted, incepted on Jan. 2, 2008; Momentum = MSCI World Momentum, incepted on Dec. 11,
2013; Value = MSCI World Value Weighted incepted on Dec. 7, 2010; Low Volatility = MSCI World Min. Volatility, incepted
April 14, 2008; Quality = MSCI World Quality, incepted on Dec. 18, 2012. All of the factor indices shown have been created
comparatively recently, and therefore, contain elements of hindsight and selection bias. All information presented prior to
the inception dates is back-tested. Back-tested performance is not actual performance, but is hypothetical. Although back-
tested data may be prepared with the benefit of hindsight, these calculations are based on the same methodology that was
in effect when the index was officially launched. Index returns do not reflect payment of any sales charges or fees.
Performance, actual or hypothetical, is not a guarantee future results. An investment cannot be made in an index. Please
note the x axis labeling denotes the end of each full year.

Foundational concepts for understanding factor investing 5

 Factor investing versus stock picking

What is the difference between factor investing and traditional stock picking, as it has long been
Insight: How to differentiate
practiced? After all, many traditional fund products have “value” or “size” in their name.
factor investing
Although traditional stock picking
The essential difference is in the security selection process. Stock picking involves leveraging
and factor investing often apply
a unique skill or information source to determine which securities are undervalued, and evaluates
similar criteria, there are tangible
characteristics of securities based on criteria defined by the investment manager. Factor
differences between the two.
investing involves a rules-based approach, picking securities that exhibit particular characteristics
Traditional fund managers select
based on solid and objective rationale drawn from quantitative data and applied using a systematic
individual securities that seem
process. Commonly, stock picking involves deliberately concentrating on the most undervalued
attractive due to a multitude of
securities, while a factor approach maintains broad diversification across securities to reduce
fundamental features. These could
security specific risk.
be specific features, meaning those
that apply only to the individual
company — such as changes in
management or new patent
registrations. However, they could Figure 4
also be features that are assigned to Factor investing differs from traditional alpha and market-weighted strategies
factors such as value and size or to
Market cap- Factor Fundamental
general market factors. It requires
weighted index investing alpha
rigorous stock specific research,
subjective decision making and, to Potential –– No active risk –– Excess return –– Excess return
pursue alpha, high stock specific benefits –– Transparency potential potential
conviction. In contrast to the usual –– Easy to understand –– Transparency –– Easy to understand
stock-picking strategies, factor –– Process risk of process –– Additional return
strategies consistently view individual –– Capacity –– Management sources
securities just as a means of –– Cost of risks
implementation of the factor –– Customizable
strategy. Factor investing relies on –– Cost
the rationale for the factor itself to –– Capacity
continue to explain returns in the
future. If the rationale holds, the Potential –– No potential for –– Active risk –– Active risk
factor should continue its usefulness. drawbacks excess return –– Requires –– Process risk
For these strategies, the crucial issue –– Limited understanding of –– Cost
is how best to define the factors and customization risk management
implement them in live portfolios to and exposures
achieve the desired outcome net of
fees over time. The skill set and
process is different even if the
desired outcome, outperforming an
index for example, is the same.
Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 6

 How the effectiveness of factors can be explained

Insight: How factors can be Empirically speaking, the data of global style factor indices show that factors have generated a
explained better return than the market over the long term. However, investors who make their investment
There are various approaches to decisions for the future also want to understand the reasons for this phenomenon. This is why
explain the effectiveness of factors. the rationale is so important.
One of them is to attribute factors to
risk premiums. According to this
approach, investors take on special
risks for which they should be Figure 5
rewarded through higher returns Why can factor premiums be expected?
(risk premiums). Therefore, the
effectiveness of the size factor, for Risk premiums Compensation for additional risks versus the broad market,
example, can be explained by the fact that is, for an undesirable return pattern.
that the shares of smaller companies
with low market capitalization can be
harder to sell in falling markets
(liquidity premium). Other factors can
be explained by the findings of Behavioral psychology Markets are inefficient due to the behavioral characteristics
behavioral finance. The momentum of investors.
effect, for example, can be attributed –– Anchoring
to herd behavior or to the tendency –– Action bias
to only take note of information that –– Loss aversion
conforms with one’s own assessment
(confirmation bias). Complex game Market structure Markets can be inefficient due to restrictions and limitations.
theory (population games) can
explain the drivers of temporary
stable trends supporting the
momentum factor as well.

Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 7

 Factors: Not always superior

While it can be demonstrated relatively easily that factor investments produce above-average
Insight: When different factors
returns over the very long term, large fluctuations and differences in returns are possible in the
are successful
short and medium term. Different factors display strengths and weaknesses in different economic
Factor strategies often perform quite
and market environments, with one factor outperforming in one environment and the other
differently in the various phases of
doing better in another environment. Successful predictions (timing) are exceedingly difficult.
the economic cycle. During economic
recovery phases characterized by
weak or accelerating growth, smaller
and more flexible companies (size)
tend to perform better, as do value Figure 6
stocks that are already trading at a Factor strategies — Success in various market phases
discount. If growth is strong, but Value Momentum Quality
decelerating, quality stocks — i.e. Size Volatility
companies with solid balance sheets
— score more points. In the second 12/97 6/99 6/01 6/03 6/05 6/07 6/09 6/11 6/13 6/15 6/17 6/19
half of the 1990s, for example, value
%
strategies performed badly when
technology stocks rallied. Momentum 100
strategies showed their strength in
the past five years during a long-
80
running bull market. Quality and
low-volatility factor strategies, on the
other hand, have worked particularly 60
well during times of crisis. However,
active timing of factor investments is
40
very difficult in practice and is not
recommended for most private
investors. It is very easy to 20
understand the behavior of factors
looking back in time when the 0
economic cycle is known. Looking
forward, it is much more difficult to
predict phases in the economic cycle -20
consistently particularly at or near
inflection points. This challenge may -40
be best left to traditional active
managers who possess this skill and Source: Invesco, MSCI from Dec. 31, 1997 to June 30, 2019 (total return, in USD). Indices: Size = MSCI World Equal
seek to exploit it through high- Weighted, Momentum = MSCI World Momentum, Value = MSCI World Value Weighted, Volatility = MSCI World Min. Volatility,
conviction security selection. Quality = MSCI World Quality. All of the factor indices shown have been created comparatively recently, and therefore,
contain elements of hindsight and selection bias. Please see MSCI disclosures at the end of this document for further
information on MSCI factor indices, indices inception dates and back tested past performance. Backtested performance is not
a guide or an indicator of future returns. Please note the x axis labeling denotes the end of each full year.

The different return patterns of factors during different market phases also offer opportunities.
As mentioned before, enhanced diversification is one potential benefit of factor investing. Over
the long term, investment factors have captured a premium over market cap-weighted indices.
Since factors often perform differently at different points in the economic cycle, factor investing
can enhance diversification. Multi factor strategies seek to exploit this benefit within the portfolio
while single factor strategies can complement the broader client portfolio.

Foundational concepts for understanding factor investing 8

 Factor strategies: active or passive?

Insight: The roots of factor Factor strategies that are implemented with rules-based ETFs have recently attracted a lot of
investing attention and have managed to pool significant amounts of investor capital. This can create the
The formal foundations for factor impression that factor strategies are always best suited to passive investment products. But a
investing were laid in the 1960s with closer look reveals that factor strategies — even as rules-based ETFs — can entail a high level of
the Capital Asset Pricing Model (CAPM) activity in terms of the steady turnover of securities. For example, the momentum strategy
naturally involves changing large portions of the investment portfolio, such as when a steady
developed by William F. Sharpe,
trend shifts after being effective for a long period of time.
John Lintner and Jan Mossin. It
made a distinction between alpha as
In any case, factor investments aren’t only reserved for passive investment products and ETFs.
a measure of excess return compared
Quite the opposite, in fact: Active management teams have been using factors for decades to
with a benchmark, and beta as
assemble and structure their portfolios — even though these often don’t carry the “factor
market risk. In the Fama-French
investing” label. A look at the history of factor research also shows that factors in active
three-factor model (1992),
management are much older than ETFs.
developed by Eugene Fama and
Kenneth French, the size and value
premia were combined with market
risk for equities. In 1997, Mark
Figure 7
Carhart expanded the model to
Factor investing — The origins
produce the four-factor model by
adding the momentum factor.
However, studies on the size and
value factors were first conducted in 1960s 1970s 1980s 1990s 2000s 2010s
the early 1980s, and the first studies
on the low-volatility factor date back
as far as 1972. Security Analysis, the
1964 1972 1981 1992 2008 2008
famous book by Graham and Dodd, The separation Low Volatility: Size: Size and value: Asset growth: Profitability:
first published in 1934, touches on of beta and alpha: Haugen and Heinz Banz finds that Fama/French Cooper, Gulan and Novy-Marx shows
many of the same concepts at the Using Markowitz’s find that low small cap stocks 3-factor model Schill find that that operating
mean variance volatility stocks outperform large adds size and asset growth profitability
heart of factors such as value and analysis, Sharpe, realize extra risk– caps value to the predicts future predicts future
quality. Therefore, factor strategies Lintner and Mossin adjusted returns market factor returns returns.
have long been used in active fund develop the 1981
Capital Asset 1973–76 Basu shows that 1993 2009 2015
management as well — just not under Pricing Model Robert Merton’s low PE stocks Momentum: Norges Bank Hou, Xue and
the “factor” label or in the systematic (CAPM) Intertemporal generate higher Jegadeesh and Investment Zhang’s q-model
way used today. Capital Asset returns than high Titman analyze a Management based on
Pricing Model and PE stocks momentum factor (NBIM) review profitability and
Richard Roll’s approach to Active asset growth
arbitrage Pricing 1981–85 1997 Management dominates long-
Theory establish a Shiller, DeBondt Carhart finds that (Ang, Goetzman & established ones.
theoretical and Thaler start a 4-factor model Schaefer)
framework for gathering evidence including 2015
factor investing against market momentum Fama and French
rationality improves add operating
performance profitability and
1983 asset growth to
Invesco launches their model, giving
its 1st quantitative rise to the 5-factor
strategy model
Source: Invesco. Illustrative examples of macro and style factors.

Foundational concepts for understanding factor investing 9

 The core differences between active and index-
based factor investing

Active quantitative managers typically use self-developed factors or multi-factor models that are
Insight: Factor investing
constantly monitored and enhanced. The active manager’s work is at the core of the optimization
through actively management
process. As a result, these strategies often lack transparency for investors — except when it
funds versus ETFs
comes to the main features and objectives. Index-based products on the other hand are fully
Factor investing can be conducted
transparent, and their rules governing how securities are selected are set once the index has
through actively managed funds
been launched.
and ETFs, both of which have
advantages and disadvantages.
ETFs commonly carry lower costs7
and may have greater transparency8
of methods and positions and certain Figure 8
tax and liquidity advantages. Actively Differences between active and index-based factor investing
managed factor strategies can have
an advantages through their Active Index-based
flexibility; continued research has
lead to a number of advancements Model updates Regular monitoring and Adjustment of the portfolio
over time and ongoing study and enhancement of factors and their according to fixed rules
modification is a valuable element of weightings to suit the market
maintaining best practices in the environment
field. In addition, actively managed Factors Individual/self-developed, often Often not self-developed, but
funds can pursue a multi-factor defined to complement other generally proven
approach to assign different factors or improve diversification
weightings to factors, depending across factors
on the market environment.
The objective is to make better use Transparency Transparent in the factors pursued Unlimited transparency of method
of the advantages offered by but more complex and less and implementation
individual factors under particular transparent in implementation
market conditions and evolve as new process
breakthroughs occur.
Costs Typically at a discount to Generally cheaper reflecting the
traditional alpha seeking strategies lower complexity
and connected to complexity of
the strategy
Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 10

 Factor investing in the fixed income area

In the bond area, factor investing is in the earlier stage of adoption, as compared to equities.
Insight: Factor investing in the
In recent years, however, many papers have been written by both academics and practitioners.
fixed income area
Further, since the rationale at the core of investment factors are not asset class specific, satisfied
Factor investing is becoming more
equity factor investors are increasingly moving on to factor applications with bonds.
advanced in the fixed income area,
as live strategies continue to become
When it comes to government and corporate bond indices, the usual weighting of securities
more common. Since bonds trade
based on market capitalization causes special problems — because it means that high weightings
over the counter without central
are assigned to the most highly indebted countries and companies, respectively. Investors will
exchanges, and many bond issues
therefore disproportionately be invested in issuers with the highest debt burden. This will
don’t trade every day like stocks,
generally be undesirable. Instead, issuers that can pay back their debts should be more in
identifying valuable insights from
demand.
bond markets can be harder than in
the equities area. In some ways,
Furthermore, the indices are often even less balanced than equity indices. For example, many
implementation may be critical and
global government bond indices have a strong US and Japan bias, while many corporate bond
more difficult than in equities.
indices primarily contain bonds from the financial sector.
Nevertheless, there are promising
approaches that indicate factor
Today, there are also some promising approaches to apply well-known style factors to fixed
investing will become increasingly
income strategies. In very general terms, value can be interpreted as meaning that a financial
important in the fixed income area as
asset is cheap relative to other bonds by some measure. The application of the quality factor to
well. Much of the same rationale that
the bond sector is viewed as particularly promising, as is the size factor by focusing on smaller
forms the basis of equity factors
issuers.
applies in bonds and much research
in this area is ongoing.

Figure 9
The most important style factors in fixed income investing

Duration –– The return of longer-dated bonds over shorter-dated bonds of similar

credit quality
–– A duration portfolio buys all treasury bonds across the maturity curve

Credit –– The return of lower-rated credit over higher-rated credit of similar

maturity
–– A credit portfolio buys all credit bonds across the maturity and ratings
spectrum
Value –– The return of holdings bonds that are at a discount to similar bonds
–– A value portfolio buys bonds with a higher spread than bonds with
similar ratings in the same industry

Quality –– High credit rating, low duration and low historical volatility
–– A quality portfolio buys and sells the top 20% of bonds sorted on
quality

Carry –– Highest overall yield

–– A carry portfolio buys the top 10% and sells the lowest 10% of bonds
sorted by this metric

Liquidity –– Age and size

–– A liquidity portfolio buys the least liquid bonds and sells the most liquid
bonds sorted by this metric

Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 11

 Factors in an investor’s portfolio — for good reasons

Now that we have gained a general understanding of factors, the key question is how factor
Insight: Tactical use is also possible
investing is used in investor portfolios and what its objectives are. In general, a strategic portfolio
The objective of factor investing is
that is diversified according to factors may reduce the risk and enhance the return potential in
normally strategic due to the long
the long term compared with the broad market. Depending on their individual starting point and
term nature of investment factors.
investment portfolio, investors may use factor strategies for different reasons.
However, a tactical use of factors is
also possible, for example, in order to
express a market view. In this way,
Some of the key considerations are:
investors who expect a positive
equity market trend to continue can • In a portfolio with traditional market-weighted strategies, index-based factor strategies
focus on momentum strategies. (frequently referred to as “smart beta” strategies) can offer a cost-efficient means of
Other investors, who may expect increasing return potential of the portfolio or used as a tool to balance overall factor
heavy volatility in equity markets in exposures.
the future, can hedge their bets with • Investors with a portfolio consisting of market-weighted strategies may use active quantitative
low-volatility strategies instead. Last factor strategies to apply customized objectives like ESG to pursue excess return or achieve
but not least, factor investing can a more effective risk diversification.
also be used in a targeted way to • Investors who have traditionally invested in fundamental active strategies may decide to add
reduce portfolio risk – with the factor strategies to increase diversification, smooth allocations, directly target factor premiums
objective of giving the investment or lower total investment costs.
additional diversification. A note of • Investors who already use index-based factor strategies might switch to active factor strategies
caution, however; applying factors to achieve more efficient implementation, allow for advancements in techniques or increase
that have historically delivered a effective risk diversification.
premium in the long term creates
an additional hurdle that must be In the process, the decision to use factor strategies in a portfolio does not have to be strategically
overcome when used tactically. motivated. As the following chart shows, factor strategies can also be used tactically.
Market trends and economic cycles
can change quickly and, sometimes
unexpectedly. In order to benefit
from tactical applications, investors Figure 10
must know when to get in and when Objectives of factor investing
to get out.
Application Tactical Strategic Risk
management

Objective Improve Reduce Improve Reduce Diversity

return risk return risk

Implementation Single factor Building a Building Add factor

strategies are portfolio using a portfolio using strategies to
used to produce a factors to factors to reduce further diversify
factor-tilt of a improve long- long-term risks portfolios and
portfolio to term return versus a market manage risk
implement potential versus portfolio
investment ideas a market portfolio
of the investor

Source: Invesco. Simplified schematic representation for illustrative purposes only.

Foundational concepts for understanding factor investing 12

 Multi-factor investing: Relevant solutions for
different investor needs

The case for multi-factor:

Insight: Typical applications of
multi-factor investing • Single-factor portfolios are not neutral to other factors due to cross-effects between factors
The benefits of multi-factor investing • A holistic approach in constructing multi-factor portfolios results in higher desired factor
are as manifold as the options to exposures compared to a naive (equal weighted) allocation of multiple single factors
combine factor strategies to meet • Multi-factor construction can lead to improved efficiency of the overall portfolio
investor needs. Distinct factors offer
diversification benefits when combined
in a multi-factor strategy. For example, Figure 11
investors seeking to build a core Multi-factor versus multiple single factors
portfolio offering exposure to equities Standard deviations versus the global stock universe (-3 to 3)
can use a multi-factor approach to • Value   • Size   • Earnings momentum   • Price momentum   • Quality
obtain a highly robust and consistent
investment process with high Factor exposure scores
capacity limits. Another example:
Many investors use strategies -0.5 0.0 0.5 1.0 1.5 2.0
managed by different managers in Integrated multi-factor portfolio
their portfolios (for example, by
investing in different funds). Adding
a multi-factor strategy to such a
portfolio can offer particular benefits Naïve combination of single factors
because of the frequently low
correlations between such a strategy
and other equity strategies. Quality

Earnings momentum

Price momentum

Value

Source: Invesco, as of Dec. 31, 2018. Factor exposure scores are shown in standard deviations from the
entire stock universe. Scores are normalized and fall between a range of -3 to +3 where -3 represents a stock with
unattractive factor scores and +3 represents an attractive stock.

In summary
We can see that investors who already have an existing equity or equity fund portfolio can try to
compensate for one factor’s recognized deficiency by adding single-factor products, such as
smart beta ETFs. For example, if an investor believes that the existing portfolio is too speculative
in orientation and doesn’t include enough securities that are more resistant to volatility, an
investment product with a low-volatility factor strategy can be added.

However, the situation isn’t always clear because it is very difficult to analyze exactly how good
the factor diversification of an existing portfolio really is and what would have to be done to
improve it. In this case, a new equity portfolio based entirely on factors may be more
appropriate. This can be based on single-factor strategies. However, this might force investors
and their advisers to make ad-hoc interventions to adapt the portfolio to changed market
conditions.

A fundamentally different approach is to assign an active manager to construct a multi-factor

portfolio with the relevant products. This requires skill and proficiency on the part of the
professional manager to weight and adapt the individual factors in the portfolio in such a way
that the investment objectives that were agreed upon — or established for the fund product —
are achieved for the investor in an optimal way.

Different objectives also require a different approach. If the objective is to achieve as much return
as possible — even with higher volatility risks — the fund manager can assign a lower value to risk
aversion as part of the portfolio optimization process and thereby assign greater importance to
higher returns. On the other hand, a long-term strategic diversification based on factors is
paramount to achieve the steadiest returns possible with manageable equity risk.

Foundational concepts for understanding factor investing 13

1 TFama, E, and French, K: ‘The Cross-Section of Expected Stock Returns’, Journal of Finance, 1992; Fama, E, and French,
K, ‘Common risk factors in the returns on stocks and bonds’, Journal of Financial Economics, 1993.
2 TRolf W. Banz, Journal of Financial Economics, 1981
3 TRobert A. Haugen, A. James Heins, Wisconsin working Paper, 1972
4 TNarasimhan Jegadeesh and Sheridan Titman, Journal of Finance, 1993
5 TActual events are difficult to predict and may substantially differ from those assumed. There can be no guarantee that
the assumptions discussed will come to pass.
6 TRobert Novy-Marx, Quality Investing; Working Paper, December 2012, revised May 2014.
7 TSince ordinary brokerage commissions apply for each buy and sell transaction, frequent trading activity may increase the
cost of ETFs.
8 TETFs disclose their full portfolio holdings daily.

Foundational concepts for understanding factor investing 14

Contact
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Zurich Telephone +41 44 287 90 00 www.invesco.ch
(Telephone calls may be recorded in the UK.)

Foundational concepts for understanding factor investing 15

Risk warnings
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Foundational concepts for understanding factor investing 16