Investors who passively tracked benchmark stock and bond indices in 2022 likely felt the pain of steep losses. What’s more, against a backdrop of potentially elevated inflation and higher interest rates, Morgan Stanley’s Global Investment Committee forecasts muted returns for those asset classes over the next several years.
But there are approaches investors can take to help boost portfolio performance without taking undue risk or incurring hefty management fees. One worth considering is “smart beta,” also known as factor investing.
Think of factor investing as a middle ground between passive and active investing.
Think of factor investing as a middle ground between passive and active investing. Like many passive index funds and exchange-traded funds (ETFs), factor-based strategies include constituents from popular stock indices like the S&P 500. Instead of weighting holdings based on market capitalization, however, these strategies offer greater exposure to index constituents with certain characteristics, or “factors”—such as those sought by active fund managers—that have been shown to deliver excess returns or lower volatility over time.
These strategies aim to outperform traditional cap-weighted benchmarks in absolute or risk-adjusted terms and usually have lower expenses than traditional actively managed funds.
They have grown steadily in number and assets over the past two decades, although their popularity has waned somewhat since 2018. As of December 2022, there were $664 billion in total assets under management with 503 U.S.-listed strategies, down about 12% from a peak in 2018.
Factor Investing ETF Strategies Have Grown in Popularity
Factor investing can be complex. Investors often have questions about which strategies have performed well and how they should consider implementing factor investing in their portfolio. Here’s what you should know.
Which Factors Have Performed Well Historically?
Certain factor-based strategies have delivered excess returns over the last 20 years, suggesting they can add long-term value to a portfolio, albeit with higher risk than their benchmark index in some cases. Here are some common, low-cost options available in highly liquid ETFs:
- Aggressive growth focuses on companies with high growth potential in revenues, earnings and other corporate fundamentals.
- Deep value targets stocks with inexpensive valuations based on metrics like price/book value, price/earnings and price/sales.
- Dividend growth focuses on companies that have increased their dividends for 20 straight years and may offer high dividend yields.1
- Momentum tracks stocks with high returns relative to the market over the last six to 12 months.
- Size provides equal portfolio weighting to each index constituent, resulting in greater exposure to smaller-cap and value stocks compared with traditional cap-weighted indices.
Meanwhile, other factors may be attractive because they are historically less risky than their benchmark index and, in some cases, may deliver equivalent or only slightly lower returns. Two examples:
- Quality focuses on companies with healthy balance sheets and consistent, high profitability.
- Low volatility does what its name suggests, targeting stocks with low realized volatility in price returns.
How Should Investors Approach Factor Investing?
To start, it’s important to note some risks. Most ETFs tracking factor indexes have limited performance histories and have not made it through a full market cycle, which warrants caution. Additionally, some single-factor strategies often experience sharp, cyclical drawdowns, and their returns may prove disappointing over one- to three-year time periods.
Considering that, Morgan Stanley’s Global Investment Office recommends a long-term approach to factor investing involving one of the following:
- Multifactor strategies: For example, an investor may choose a strategy that combines momentum, quality, size and value by maximizing exposure to stocks with several of those factors, in combination. This approach may allow investors to gain greater portfolio diversification and rely less on any one factor to help drive returns.
- A well-diversified portfolio of single factor strategies: For example, part of an investor’s portfolio might be allocated to momentum, another to dividend growers and still another to quality. This approach may allow investors to pursue multiple goals, such as improving returns, generating income or reducing risk.
- A combination of the two: Combining the above two approaches may provide investors the highest degree of choice, offering both diversification and flexibility.
We also prefer “factor-concentrated” strategies, which offer exposure only to the stocks in an index that strongly exhibit a particular factor, rather than “factor-tilted” strategies, which invest in the entire index but increase the investor’s exposure to a desired factor. We believe factor concentration can provide greater consistency in results across different market environments.
Certain factor-based strategies have delivered excess returns over the last 20 years, suggesting they can add long-term value to a portfolio.
A Potential Boost for Your Portfolio?
Overall, factor investing may prove beneficial to investors looking to boost their portfolio’s risk-adjusted performance over the long term.
Work with your Morgan Stanley Financial Advisor to determine how factor investing might help you achieve your long-term investment goals.
You can learn more by requesting a copy of the Global Investment Committee report, Decoding Smart Beta, which more closely examines the performance of key U.S. large-cap equity factors.
Questions to Ask Your Morgan Stanley Financial Advisor:
- Are there any factor investing strategies that might help me reach my long-term investment goals?
- What are some ways to invest in single or multiple factors that might enhance returns or reduce volatility in my portfolio?
