Funds & wrappers
Factor investing
Also called Smart beta
Building portfolios around characteristics that have historically explained returns.
How it works
The best-documented factors are value, size, momentum, quality and low volatility. Each is a rule for tilting a portfolio rather than a view on individual companies.
The academic case is that these represent either compensation for a risk or a persistent behavioural error. Which of the two matters, because risk premia should persist and errors get arbitraged away.
Where it misleads people
Factors underperform for a decade at a time. Value spent much of the 2010s losing to the market, and most investors who adopted it did not survive the stretch.
Related terms
- Value investingBuying assets for less than an estimate of their intrinsic worth, with a margin of safety.
- MomentumThe tendency of recent winners to keep outperforming, and losers to keep underperforming, over months.
- Capital asset pricing modelA model saying an asset’s expected return depends on the risk-free rate plus its market risk.
- Index fundA fund that aims to match an index rather than beat it, at very low cost.
- AlphaReturn above what the risk taken would ordinarily have earned — the part attributable to skill.
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