What is factor investing?

Global markets are made up of dozens of asset classes and millions of individual securities…making it challenging to understand what really matters for your portfolio. But there are a few important drivers that can help explain returns across asset classes. These FACTORS are broad, persistent drivers of return that are critical to helping investors seek a range of goals from generating returns, reducing risk, to improving diversification.

Today, new technologies and expanding data sources are allowing investors to access factors with ease.

Factors are the foundation of investing, just as nutrients are the foundations of the food we eat. We need carbohydrates and protein to power through the day, which we can find in different foods like bread, milk, and fruit. Putting together a balanced diet means understanding what nutrients are contained in our food, and choosing the mix that best supports our body’s needs.

Similarly, knowing the factors that drive returns in your portfolio can help you to choose the right mix of assets and strategies for your needs.

There are two main types of factors that drive returns. Macro factors like the pace of economic growth and the rate of inflation can help to explain returns across asset classes like equity or bond markets.

Style factors can help explain returns within those asset classes. For example, Value stocks – those that have low prices relative to fundamentals – have historically generated returns greater than the broad market.

Factors can help us build portfolios that better suit individual needs; just as knowing the nutrients in your food can help your body perform. Similarly, investors looking for downside protection in a volatile market environment might add exposure to minimum volatility strategies to seek reduced risk, while Investors who are comfortable accepting increased risk might look to more return-seeking strategies like momentum.

Now – why do factors work? Extensive research, including that of Nobel prize winners, has proven that certain factors have driven returns for decades. These factors have generated returns due to the following three reasons: an investor’s willingness to take on risk, structural impediments, and the fact that not all investors are perfectly rational all the time.

Some factors earn additional returns because they involve bearing additional risk and may underperform in certain market regimes.

Some factors arise from structural impediments, those investment restrictions or market rules that make certain investments off-limits for some investors, creating opportunities for others who can invest without those constraints.

And finally, some factors capture investor behavior, that is, actions of the average investor that are not always perfectly rational. Sometimes people want French fries instead of salad even if they are watching their cholesterol. These behavioral biases can give rise to investment opportunities for those who can take on a contrarian view.

Let’s discuss ways to access factors. Advancements in technology and data allow investors to take advantage of these time-tested ideas in new ways, from smart beta to enhanced factor strategies.

Smart beta strategies target factors using a rules-based approach, usually with the goal of outperforming a market-cap weighted benchmark. Smart beta strategies are now widely available in ETFs and mutual funds, making factor strategies affordable and accessible to every investor.

Enhanced strategies use factors in more advanced ways - trading across multiple asset classes, sometimes investing both long and short. Investors use these enhanced factor strategies to seek absolute returns or to complement hedge fund and traditional active strategies.

Factors can help to power your investments and can help to achieve your goals.

BlackRock is a leader in factor investing, launching the first factor fund in 1971 and driving innovation in the category for over 40 years.