Factor Investing: What Is It and Does It Produce Superior Returns?

Updated on March 21, 2024 Updated on March 21, 2024
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Nobody likes losing money in the stock market. There’s no way of predicting it, and your earnings can swing wildly from year to year. But what if you could tilt your portfolio in a way to enhance returns? That’s what factor investing attempts to do. But what is it, should it be a part of your financial planning toolkit, and which robo-advisors use it best?

What Is Factor Investing?

Factor investing is an investment philosophy that attempts to figure out what ‘factors’ involved can explain the difference in stock market returns.

This approach relies on observable data, such as financial information and stock prices, to explain the differences. It doesn’t use speculation.

Imagine It This Way

Index investing is where you attempt to mirror the market by purchasing most of the asset classes within it. Normally those investments would be weighted depending on the value of a particular company.

If Company A is worth $100 million and Company B is worth $60 million, then you’d expect to own $100 of Company A for every $60 of Company B you own.

Factor investing is where you look at outside factors and slightly tweak your investment portfolio. For example, you might see Company B is a smaller company that’s more profitable and owns factories, whereas Company A only provides services.

Using a factor model, your asset allocation might be closer to $65 of Company B for every $100 of Company A.

With factor investing, you’re not flipping standard indexing on its head. You’re just using a little bit of math and common sense.

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The investment strategy is to move equity portfolios towards or away from identified factors with the overall goal of generating long-term stock returns.

We’re interested in factor investing because several Robo-advisors offer factor portfolios without charging the fees active managers would charge.

Smart investing is all about getting nuanced financial advice and investment management without paying for a human advisor service.

Types of Factors

Style Factors and Macroeconomic Factors

Macroeconomic factors capture broad risks across asset classes. Style factors attempt to explain returns and risks within asset classes.

Some of these factors might be asset growth, factor returns, size factors, value factors, risk factors, and leverage factors.

This strategy departs from traditional thinking regarding portfolio diversification in terms of asset classes and portfolio weightings.

As world-class investor Larry Swedroe put it, “consider diversification by the exposure to factors that determine the risk and return of a portfolio.” 

Larry Portfolio

This portfolio's goal is to be both high performance and low volatility. It achieves its performance by tilting your portfolio to higher-risk stocks that are underpriced. Its low volatility is due to only holding 30% in stocks while 70% goes to bonds.

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Mr. Swedroe’s portfolio invests 70% in bonds but due to its factor tilts, still manages to perform exceptionally well against typical portfolios (like the common 60/40 stock/bond allocation) over the long-term.

A lot of academic research has gone into determining which factor strategies are most likely to produce higher returns and limit your overall risk.

Different Robo-advisors choose different factors they think will lead to the best results. The best Robo-advisors throw four or five factors into the mix while some only use a single one.

Some algorithms say companies only using factories to build things produce higher returns than companies that only offer intangible services.

I think I’ll invest slightly more in companies with actual factories.

There are dozens of factors you can focus on. You can even choose factors that are outside of potential market returns but line up with your morals.

For example, Wealthsimple uses Halal investing, which focuses on companies that follow Islamic law.

Feel like you have a handle on it? If not, that’s okay. The point is, many Robo-advisors use their automated investing platform to do this for you.

There are many “brands” of these algorithms, such as Smart Beta, Risk Parity, and Direct Indexing.

Some Robo-advisors have these features and some don’t. Finding out what it’s going to cost you to take advantage of these factor investing algorithms is why we’re here today.

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Factor Investing Using Smart Beta

Probably the most common factor investing algorithm is Smart Beta. In finance ‘Beta’ is a measure of a stock’s risk compared to the overall market. Smart Beta is trying to be smart about which risks you take.

The Smart Beta portfolio includes certain ETFs that don’t weight their holdings only on market capitalization. These are known as Smart Beta equity ETFs.

They make rules-based adjustments to their portfolio based on predetermined factors that the academic research has determined are keys to winning portfolio construction.

Several Robo-advisors use Smart Beta including Betterment, Charles Schwab Intelligent Portfolios, and Wealthfront. Not all Robo-advisors use the same factors in determining how heavily to weight each fund.

For example, Betterment uses four key factors:

  • Good value
  • High-quality
  • Low volatility
  • Strong momentum

Whereas Wealthfront uses five key factors:

  • Value
  • Momentum
  • Income
  • Low market risk
  • Low volatility

Many factor-based investing models use only a single factor, such as equity factors.

Betterment Goldman Sachs Smart Beta

Betterment teamed up with Goldman Sachs to create a Smart Beta option where you can choose between 0%-100% stocks.

They offer this on all Betterment accounts. It doesn’t cost any more on the management fee front but the expense ratio increases as your portfolio inches closer to 100% stocks.

They offer the smart beta investing approach for those who want to use factor investing strategies to take on more risk than they’d be able to attain using Betterment’s Core Portfolio.

The idea is to build a fund that generates excess returns based on past performance.

The factors for Betterment:

Good Value: measured by price to cash flow, price to sales, and price to book value ratios.

High Quality: measured by gross profits to total assets.

Low Volatility: measured by the standard deviation of returns.

Strong Momentum: measured by risk-adjusted returns over a defined period.

  • Betterment Account Minimum for Smart Beta: $0
  • Tax-loss harvesting automatically available
  • Rebalancing automatically available
  • Account Management Fee: 0.25% Betterment Digital, 0.40% Betterment Premium

Charles Schwab Intelligent Portfolio Smart Beta

The Charles Schwab Intelligent Portfolio Smart Beta ETFs divide into three types: Risk-oriented, Return-oriented, and Other.

Risk-oriented: focuses on low-volatility ETFs and companies with a long track record.

Return-oriented: focuses on momentum factors (weight stocks based on price momentum), quality factors (weight stocks based on low debt, consistent earnings, and high levels of profit measures), and fundamental factors (weight stocks based on cash flow, sales, and dividends plus buybacks).

Other: focuses on equal weight ETFs (provide the same weight to every stock in a given index).

You won’t have to pay an additional fee to gain access to Charles Schwab’s smart beta but the minimum investment is $5,000. They also offer tax-loss harvesting once you reach the $50,000 threshold.

  • Minimum Investment: $5,000
  • Tax-loss harvesting: Available for accounts over $50,000.
  • Automatic daily rebalancing
  • Account Management Fee: $0

Wealthfront Smart Beta

Wealthfront also uses Smart Beta to replace their typical ETF with a combination of large-cap and mid-cap stocks.

The difference between their standard ETF and their smart beta ETF is the portfolio weight isn’t based on the size of the company. Instead, they’ve determined five factors are important to drive investment decisions.

Stock level tax-loss harvesting and smart beta are available for no additional charge.

The only catch is Wealthfront clients have to have a portfolio value of at least $100,000 to be eligible for stock level tax-loss harvesting and $500,000 to be eligible for their smart beta algorithm.

These options, along with their standard tax-loss harvesting are rolled into one service called PassivePlus.

The barrier to entry for Wealthfront is much higher than Betterment, but Wealthfront has a few tricks up their sleeve such as Risk Parity and Direct Indexing.

We’ll get into both of those in a minute.

  • Wealthfront Account Minimum for Smart Beta: $500,000
  • Stock-Level Tax-loss harvesting: Available for taxable accounts at $100,000
  • Automatic Rebalancing
  • Account Management Fee: 0.25%

Popular Robo-Advisors Featuring Factor Investing

Minimum Investment:

Management Fees:

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Tax Loss Harvesting:

Portfolio Rebalancing:

Assets Under Management:

Minimum Investment:

Management Fees:
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Tax Loss Harvesting:

Portfolio Rebalancing:

Assets Under Management:

Minimum Investment:

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Invest your first $5,000 free, for life

Tax Loss Harvesting:

Portfolio Rebalancing:

Assets Under Management:
$10 billion

Factor Investing with Risk Parity

Depending on your risk tolerance, the Risk Parity fund is an alluring option. Risk Parity is a system that’s meant to limit the downside risk of your investments.

The idea is any old fund will do well in a bull market but the Risk Parity Fund is a low-cost fund that does well in bear markets.

The way they hedge their risk is by holding more bonds than equities in their portfolio (but leveraging the bonds).

This means deviating from the standard 60/40 stock/bond split. Theoretically, leveraging bonds should generate returns similar to an all stocks portfolio but without the volatility.

Ray Dalio created a hedge fund called Bridgewater Associates and it catered to the ultra-wealthy and institutional investors.

The Risk Parity fund from Wealthfront is their attempt to copy Ray Dalio’s famous hedge fund for a fraction of the price.

Risk Parity is controversial for risk management. Wealthfront will only allow an investor to have up to 20% of their portfolio in the Risk Parity Fund.

  • Available for taxable investments $100,000 or more
  • Stock-Level Tax-loss harvesting: Available for taxable accounts at $100,000
  • Automatic Rebalancing
  • Annual Fee: 0.50% for Risk Parity (max 20% of the portfolio can be invested in the Risk Parity fund. The other 80% or more of your portfolio will incur the standard Wealthfront fee of 0.25%. Your actual all-in portfolio management fee would be around 0.30%).

Direct Indexing

Wealthfront doesn’t stop with Risk Parity or Smart Beta, they also offer direct indexing. Direct indexing gives investors the ability to invest directly into indexes.

This means they don’t have to go through the ETF or mutual fund structure.

Let’s take the S&P 500 as an example. If you buy an S&P 500 index fund then you are buying parts of all 500 companies within that index.

How much of each company you buy is up to the account manager for that fund. With Direct Indexing, you (or a financial advisor or computer) decide how much of each company you want in your portfolio.

The main benefit of Direct Indexing, other than greater portfolio control, is it allows you to take advantage of tax-loss harvesting at the stock level, not just the overall fund level.

Wealthfront offers direct indexing at the $500,000 account minimum for no additional fee.

Personal Capital uses its own brand of direct indexing called Smart Weighting. It maintains evenly weighted sector exposure when designing portfolios.

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Halal Investing

Not all factor investing models are concerned strictly with market returns. Halal investing through Wealthsimple is the first Robo-advisor algorithm geared toward complying with Islamic law.

This gives Muslims the ability to invest in a way that lines up with their ethics. The fund has over 50 companies that don’t profit from gambling, arms, tobacco, or other restricted industries.

The goal of Halal investing is not simply to beat the market but to beat the market while complying with Islamic law.

  • Minimum investment: $0
  • Automatic rebalancing
  • Tax-loss harvesting available
  • Management Fee: 0.50% (0-$100K) 0.40% ($100k+)

Is Factor Investing Right for You?

Factor investing is hard to wrap your mind around. Some of the best Robo-advisors don’t dive into factor investing but are still great at wealth management.

Ellevest, SoFi, and Vanguard Personal Advisor Services don’t offer smart beta. They’re still at or near the top of any best Robo-advisor list.

Factor investing might not be the number one thing you use to determine which Robo-advisor is best for you, but it’s nice to know that some Robo-advisors are thinking about more than just mirroring the market.

Wealthfront has several factor investing features built directly into their Robo-advisor. You’ll need a fair amount invested in order to take advantage of these features, but for high dollar accounts, these added bonuses are a huge plus.

Betterment doesn’t charge anything extra to take advantage of their smart beta algorithm. If you were between Betterment and another Robo-advisor, this might be the tie-breaker you’re looking for.

Overall, Robo-advisors that offer some form of factor investing generally have a leg up over Robo-advisors that don’t.

Whether they charge high or low fees for this feature, and the minimum balance needed to access it, can be a determining factor.

Talk to your financial planner to see if factor investing might be right for you. Using a Robo-advisor to reach your goals might be the easier option.

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David Lautaret - Contributor David Lautaret is a thirty-something writer based in Portland, OR. His passion for financial independence stems from unrelenting, low-grade anxiety that he doesn't know enough which explains why he can't stop educating himself on the subject. He has a degree in Business but prefers to use cartoons and humor to make his points. He's a husband to a beautiful wife and a tremendous father to a super cute baby girl.
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