The ins and outs of factor-based investing
Want to experience less volatility in a portfolio? Add a little extra income? Then consider adding factor-based funds to your investments. Here’s what you need to know.
Updated 
4 min. read
Over the last few years, a plethora of exchange-traded funds (ETFs) have come to market. While many of these ETFs have been more traditional index-trackers, a number have also been smart-beta ETFs, or products that employ factor-based investing.
Factor investing has long been used by institutional investors, but, thanks to these ETFs, any do-it-yourselfer can tap into this strategy.
Before you do, though, you’ll need to know what it’s all about. Mark Raes, head of product for ETFs and mutual funds at BMO Global Asset Management, explains the ins and outs of factor-based investing.
What is factor-based investing and how does it work?
Factor-based investing employs certain strategies with the goal of increasing returns or adjusting risk. The main factors, or characteristics, that have shown enhanced risk-return profiles over time include income, quality, value, small cap, low-volatility and momentum.
A factor-based approach combines aspects of active and passive investing where you’re attempting to enhance these exposures. Factor-based investing can be a powerful strategy to help boost performance and position on market risk.
How are smart beta ETFs different from active funds?
Smart-beta funds follow a rules-based approach to focus on one or more factors instead of investing at market capitalization weights in the entire benchmark index, which is what you’d do if you held a traditional low-cost passive ETF. That’s different from active investing, where you’d select a subset of securities you think will return more than an index based on factors and security specific attributes and then weigh them how you see fit. Smart beta investing falls somewhere in the middle and captures the best of both strategies.
What specific role does factor-based investing play in a portfolio?
It depends on how a factor is being applied. You might use a factor-based fund to reduce your exposure to a broader market, like the S&P 500, for instance, and instead focus on a certain sector or part of the market that might have more upside.
They can also be used to diversify, or adjust the risk in your portfolio, too. Using a low-volatility factor ETF, for instance, is a great way to smooth out some of the market’s ups and downs.
How can an investor add factor-based investments to a portfolio?
This is where ETFs have really added to an investor’s toolkit. With direct-stock holdings, if you wanted to be more exposed to dividend stocks, or wanted to decrease volatility, you would have to sell your equities and buy another subset of securities. ETFs, though, provide a single-ticket solution to immediately reposition your portfolio while remaining fully diversified.
When it comes to adding smart beta to a portfolio, it really depends on what you’re trying to do. If you’re looking for additional income, you could buy a dividend factor ETF. If you want to have equity exposure, but have a lower risk tolerance, then you may opt for a low volatility ETF. If you feel the market is turning and there’s opportunity for growth, then a value factor ETF may be the way to go.
There are different approaches, depending on what you're looking to do with your portfolio. Keep in mind, though, that certain factors, such as momentum and value, are typically higher risk than the general market.
What are some of the key risks that investors should know going in?
It’s important to understand that different ETFs will access the same factor in different ways. One might weigh companies differently than another or select securities in a different way. Another thing to be mindful of is whether the ETF considers things like sector concentration. Do your research.
How does this strategy work in a particularly volatile market like now?
In a period of heightened market turbulence, a lot of investors will look to a lower volatility ETF as a complement or replacement for a broad-market index. That way you’re staying invested, but you typically don’t get the same downside as you might if you’re invested in the full market.
With all the volatility we’re experiencing right now, low volatility and quality ETFs are getting plenty of attention, which they should. Use them, and other factors, right and you may be able to smooth out more of the market’s ups and downs.
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