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The Ultimate Guide to Smart Factor Strategies

Discover everything you need to know about smart factor strategies, including the different types of factors, key risks such as concentration, and the smart factor strategies calculated by Index One.

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What Are Smart Factors?

Smart factor investing is reshaping how investors build portfolios.

Smart factors are systematic, research-backed characteristics of securities that help explain differences in returns across stocks or other assets.

These factors go beyond traditional passive investing by emphasizing certain traits historically linked to outperformance or risk mitigation.

By targeting specific drivers of risk and return, smart factors offer a rules-based, evidence-driven approach to portfolio construction.

Advantages of Smart Factor Strategies

Smart factors provide a more strategic way to access market returns, often bridging the gap between passive and active investing.

Instead of relying on subjective stock picking, factor investing uses quantitative rules to tilt portfolios toward characteristics like quality, value, or low volatility.

Types of Smart Factors

Here are the most widely used and academically supported factors:

Value:

Value stocks trade below their intrinsic worth, typically identified by low price-to-earnings (P/E) or price-to-book (P/B) ratios. This strategy aims to capture long-term outperformance by investing in undervalued companies.

Example: BX Smart Alpha US Large-Cap Value Strategy

Momentum:

Momentum strategies focus on stocks that have exhibited strong recent performance, based on the idea that winners often continue to outperform in the short to medium term.

Example: BX EU Large Cap Momentum 20

Quality:

Quality factor strategies target companies with strong balance sheets, high return on equity, and consistent earnings. These stocks tend to offer resilience during market downturns and strong performance over the long run.

Example: Brompton Index One U.S. Cash Flow Kings

Low Volatility:

Low volatility strategies invest in stocks with relatively stable price movements. They aim to reduce portfolio risk while maintaining steady returns, appealing to more conservative investors.

Example: BX/Thor Low Volatility SDQ Index

Size:

The size factor emphasizes small-cap stocks, which tend to offer higher growth potential over time, albeit with greater volatility compared to large-cap stocks.

Example: BX/FT American Disciplined Small Cap Index

Dividend Yield:

Dividend yield strategies focus on companies with high and sustainable dividend payouts, providing investors with regular income and potential downside protection.

Example: BX US Dividend Yield Plus Momentum

Risks and Considerations of Smart Factor Strategies

Cyclicality:
Individual factors can underperform for extended periods depending on market conditions.

Overlap:
Certain factors may include similar stocks, leading to potential concentration risk within a portfolio.

Complexity:
Multi-factor strategies can be complex and require a solid understanding of how different factors interact and impact performance.

Frequently Asked Questions

Index construction refers to the process of creating and maintaining a market index, which is a hypothetical portfolio of securities that represents a specific segment of the overall market.

While direct indexing requires you to choose amongst pre-packaged solutions, custom indexing allows for unlimited customization within different factors, allowing investors to build a portfolio that truly reflects their unique investment goals and preferences.

While active investing strategies focus on individual securities and a more hands-on approach, passive investing strategies tend to focus on purchasing shares of index funds or ETFs in an attempt to mirror or beat the performance of market indexes.

A security is the ownership or debt with value. A stock is a type of security that gives the holder of the stock ownership or equity of the publicly-traded company.

A share is a unit of ownership measured by the number of shares you own, whereas a stock is a unit of equity, measured by the percentage of ownership of the company.

A portfolio manager handles investments and other financial products that make up a portfolio. An asset manager may also manage portfolios, but they mainly handle cash and assets, which a portfolio manager does not.

While a benchmark only serves as a standard to measure index performance against, an index is created for a variety of reasons, and one of its purposes is to act as a benchmark. In other words, a benchmark is usually always an index, but an index doesn’t necessarily have to be a benchmark.

Rebalancing is a more automated process where price and market-cap weighted indices are rebalanced automatically. Reconstitution, on the other hand, requires the manual adding and removal of securities from an index, based on whether or not these securities are meeting index criteria.

An index fund is a mutual fund which tracks an index, while an ETF is an exchange traded asset tracking the performance of an index.

An index is a hypothetical basket of stocks. In order to invest in an index, it would need to be an investable product that tracks an index. A few examples of an investable product are mutual funds and ETFs.

Index rebalancing refers to the process of adjusting the composition and weights of securities within an index. It is typically done periodically to maintain the index's target representation and desired characteristics. Index rebalancing helps maintain the integrity of the index and ensures that it continues to accurately reflect the targeted market segment. It allows for adjustments to account for changes in market conditions, company fundamentals, and other factors that may affect the composition and weights of the index components.

Creating a stock index involves several steps and considerations, including defining the index objective, selecting the index components, determining the weighting methodology, setting the initial index values, establishing the index calculation methodology, regular maintenance and rebalancing, index calculation and dissemination and index governance and oversight.

Constructing an index for research purposes involves a tailored approach to meet specific research objectives. This includes defining research objectives, selecting the relevant securities, determining inclusion and exclusion criteria, determining weighting methodology, setting the index universe, establishing index calculation methodology, data collection and management, performing backtesting and validation, documenting index construction methodology and analyzing and interpreting results.

Creating your own index requires careful consideration of various factors, including your investment objectives, the availability of data, and the resources needed to maintain and calculate the index. It may be beneficial to seek professional advice or consult with experts in index construction to ensure the integrity and accuracy of your self-created index.

Creating your own index fund involves several steps and considerations: define the investment objective, select the index components, determine the weighting methodology, set the initial fund composition, establish a rebalancing strategy, implement the fund's portfolio, track and monitor performance, consider legal and regulatory requirements, consider administration and custody, develop a distribution strategy, and comply with reporting and governance.

Commonly Used Terms

custom indexing is the process of setting specific parameters on the stocks you’d like to invest money in, allowing you to personalize your investments based on your individual values, goals, preferences, risk tolerance and tax positioning.

direct indexing is an investing strategy that involves purchasing the individual stocks within an index, maintaining the same weights in the index.

active management involves an investment manager making investment decisions by tracking the performance of an investment portfolio.

passive management involves a fund’s portfolio mirroring a market index, by selecting stocks to be included in a portfolio, unlike active management.

A market index is a hypothetical portfolio that contains investment holdings. The value of a market index is based on the prices of the underlying holdings.

EHM, or efficient market hypothesis is a theory coined by Eugene Farma, which states that active managers can beat the market only for a given period of time, as their success is simply a matter of chance. EHM suggests that long-term passive management delivers better results than asset management.

active investing involves the ongoing buying and selling of securities by monitoring market index.

passive investing is a long-term strategy that involves buying securities that mirrors a market index.

thematic investing focuses on investing in long-term or macro-level trends. Examples of thematic investment themes include water, robotics & AI, gaming & e-sports, and space exploration.

ESG investing emphasizes on investments that prioritizes optimal environmental, social and governance outcomes.

factor investing is a type of portfolio management strategy that targets quantifiable metrics or factors that can explain differences in stock returns. These factors often include value, size, volatility, momentum, and quality.

exchange traded funds, or ETFs refer to a type of investment fund that is traded on a stock exchange. An ETF usually tracks a generic market index and allows an investor to potentially lower risks and exposure, while diversifying their portfolio.

A registered investment advisor, or RIA, is an individual or firm that advises clients on investment decisions and manages their investment portfolios.

backtesting allows an investor to test an investment strategy using historical data to assess how it would have performed before earning actual returns.

rebalancing involves the process of realigning the weightings of assets within a portfolio, by buying or selling the assets to maintain the original or desired level of asset allocation or risk.

a systematic portfolio contains securities that maintains a price higher than the predetermined level by a systematic manager. A systematic portfolio strategy invovvles trading decisions based on market price trends.

a rules-based investment strategy follows smart investment rules and aims to deliver active returns in a cost-efficient manner.

an active return is the percentage difference between a benchmark and the actual return.

an index provider is a firm that creates, calculates and maintains market indices based on any given investment strategy.

sustainable investing is a type of investment strategy that prioritizes environmental, social and corporate governance impacts before investing in a particular company, venture or fund. It is also called ESG investing or SRI.

an investment strategy is a set of principles that guide an investor to make sound investment decisions based on their financial goals, values, risk tolerance and preferences.

alpha strategies are active investment strategies that choose investments that have the potential to beat the market. Alpha is also known as “excess returns” or “abnormal rate of return.”

benchmarking is the process of setting a standard against which the performance of an investment strategy can be measured.

reconstitution is the re-evaluation of a market index to ensure that an index reflects up-to-date market cap and is balanced.

a bond is a type of security where the issuer of a bond owes the holder of the bond a debt, and the issuer is obligated to repay the principal of the bond at the maturity date, as well as interest on the bond.

asset allocation is the process of dividing an investment among different types of assets, such as stocks, bonds and cash.

quant, or quantitative analysis, is the process of using mathematical and statistical methods to make investment decisions.

index funds are a type of mutual fund or exchange-traded fund (ETF) that aim to replicate the performance of a specific market index.

a mutual fund is a type of investment fund that pools money from several investors to purchase securities.

derivative structured products are financial instruments that combine derivatives with other underlying assets to create investment products with unique risk and return characteristics.

similar to mutual funds, a hedge fund is a type of pooled investment fund that trades in relatively liquid assets. Hedge funds primarily use portfolio construction, complex trading and risk management techniques in an attempt to improve performance.

traders who watch market prices know when an index fund will update its components, allowing them to front-run the trade by buying or selling the shares to get ahead of the market and gain an edge. This is not considered illegal because it rewards individuals who pay close attention to information that already exists in the market. However, SEC Rule 17(j)-1 prohibits insiders from taking advantage of their knowledge of client trades for personal gain.

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