The financial crisis of 2007–2009, however, revealed otherwise, as stocks, bonds and alternative investments all moved largely in the same direction at the same time. Since then, investors seeking new ways to manage risks and enhance returns have been looking more closely at implementing factor-investing strategies to diversify their asset allocation and dig deeper into what characteristics make up their portfolio holdings.
Factor investing, which is often accessed through smart beta exchange-traded funds, aims to identify specific factors that may offer excess or differentiated returns when targeted within a strategy. The five factors most widely recognized are size, momentum, low volatility, quality and value.
Factor investing has attracted considerable attention of late, with high-profile investors such as Research Affiliates' Rob Arnott and AQR's Cliff Asness waging well-publicized debates in the media over its merits. With the growing interest in this investment methodology among advisors and their clients, it is important to understand what factor-based investing entails and when and how it is appropriate for long-term asset allocations.
To clarify the focus of factor-based strategies, keep in mind an analogy that the investment consultant Eugene Podkaminer once coined: "If asset classes are like complex molecules, factors are the atoms that serve as building blocks." Rather than seek diversification across asset classes — stocks vs. bonds, for example — factor-based investing aims to diversify across certain basic, objective characteristics that help to explain risk and return, such as value, size and volatility.