What is
Factor Investing?

In the world of investment management, sometimes financial jargon
can be confusing and intimidating to investors. The purpose of this article
is to examine a popular investment strategy – factor investing –
and make it easy to understand.

Factor investing is a field that has long been studied but has gained an incredible amount of momentum in recent years with the proliferation of ETFs that offer exposure to different types of factors and factor investing strategies. So, to understand what factor investing is and how an investor can incorporate a factor investing strategy into their portfolio, the question that must be answered first is: what is a factor?

A factor is simply a means of grouping stocks based on certain characteristics that can be tracked. A factor investor would make the case that stocks with similar characteristics tend to perform similarly in certain market environments. By grouping stocks in this way, factor investing allows investors to position their portfolios to take advantage of different market conditions.

What is a simple example of a factor?

Suppose you aren't familiar with factors, or it isn't part of your investing vocabulary. In that case, you might be surprised to find you likely already use some form of factor investing in your overall investment strategy. For example, size is a factor and is perhaps the most widely used of the factors.

In the investment management landscape, "size" refers to a company's market capitalization (total number of a company’s outstanding shares multiplied by current market price of one share). Most well-diversified investors will try to own a variety of different market capitalization stocks in their investment portfolio. In a well-diversified portfolio, investors will hold the largest market capitalization stocks, commonly referred to as large or mega-cap stocks, down to the smallest stocks, commonly referred to as small or micro-cap stocks, depending on the investor's risk tolerance and level of sophistication.

The thought process behind owning companies of different sizes is that it diversifies investment risk. Companies of varying sizes exhibit different characteristics and performance during various market conditions, so holding companies of all sizes in a portfolio may allow an investor to take advantage of various market conditions by increasing or decreasing their exposure to different sized companies with the goal of maximizing returns and minimizing risk.

Another example investors may be familiar with exists in the mutual fund structure. Most mutual fund managers have a specific process they follow when selecting stocks. For example, many mutual funds use value strategies where they try to identify companies with a market price that is trading at a discount to their intrinsic or perceived value. So, if you own a mutual fund, whether you're aware of it or not, odds are the manager of that mutual fund uses at least one factor in their stock selection process to choose what companies to invest in.

Pictured here is a Morningstar Equity Style Box, which tries to show where a fund falls along a continuum of size, value, and growth. The Morningstar style box is one of the most popular means of evaluating mutual funds, which many investors are already familiar with, and uses two common factors (size and value/growth) to classify a fund.

What are the most commonly used factors?

Now that we have a baseline understanding of what a factor is, let's look at the most commonly used factors in investment management. There are four main factors investors follow:

• Momentum: the likelihood a high-performing stock will continue to perform well
• Volatility: the variance of returns for a stock, often associated with growth stocks, which swing up and down
• Quality: the quality of a business model and the company's competitive advantage
• Value: the measurement of a stock's market value compared with its intrinsic value

The picture shows an example of the four factors broken out into both their traditional and non-traditional sides. The four traditional factors are high momentum, high quality, high value, and low volatility stocks. These factors all have troves of academic research claiming they create excess returns over time. At Pacer, we believe investors can produce excess returns over time by incorporating these factors into an overall investment strategy.

What factor investing options are available to investors?

ETFs have allowed investors to gain access to these factors in ways that were previously much more difficult. When it comes to ETFs, there are three types of factor funds. The first way investors can gain exposure to these factors is through investing in a single factor, typically in the form of a single factor ETF. For example, index providers such as S&P will construct an index constituted of "high quality" or "low volatility" stocks, and investors can purchase an ETF tracking that index. This allows the investor to gain exposure to the factor of choice in their portfolio.

The second option available to investors is blended factor funds. These strategies invest in two or more factors simultaneously and are designed to diversify the risk of investing in a single factor.

The third option available to investors, which we prefer at Pacer ETFs, is multifactor rotation, which rotates between different factors and attempts to maximize performance.

Why do we believe in multifactor rotation?

Although each of the four traditional factors have been shown to outperform broad-based benchmarks over the long-term, there are short-term periods in which each of the factors discussed will inevitably underperform the index they track. Additionally, there tends to be a wide variance in the performance of each of the different factors in different market environments, and each year some factors will outperform the benchmark while others will underperform.

If an investor chooses to simply invest in a single factor strategy, they are subject to the performance of that factor during their holding period and could experience underperformance vs. the benchmark in the short-term. Suppose an investor chooses to invest in a blended factor index. In that case, they can potentially dilute the performance of certain factors they've gained exposure to and exhibit similar performance to the benchmark. For example, if someone invests in a fund that has exposure to low volatility stocks and high quality stocks in a year when low volatility outperforms the benchmark but high quality underperforms, the exposure to high quality stocks will act as a drag on their overall performance that year.

This is why we at Pacer ETFs believe in using multifactor rotation as a means to maximize investment returns. We believe investors can take advantage of the dispersion of performance of the different factors by strategically owning the factors exhibiting the best risk-adjusted performance during a given time period. By starting with a universe of traditional and non-traditional factors and rotating tactically between the factors currently in favor, investors can take advantage of different market environments by owning the groupings of stocks most likely poised to take advantage of current market conditions.