Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 182

Why is factor investing a ‘thing’?

There’s a lot of hype around a trend called ‘factor investing’ which (as part of broader ‘smart beta’ thinking) has been called “the fastest growing segment of the investment management industry” (for example, this article). But what is factor investing, why is it important and why do many believe it is more than just a fad? This is written from the perspective of a large superannuation fund equity investor.

Starting with the basics

Let’s begin with the simple notions of ‘beta’ and ‘alpha’ in an equity portfolio. Broadly, beta (denoted by the Greek letter ß) captures the amount by which an equity portfolio moves with the market. So, a passive strategy which tracks the broad market (for example, S&P/ASX 200 or MSCI World) will have a beta of 1. On the other hand, alpha (denoted by the Greek letter a) captures the amount of portfolio movement not related to the market. Superannuation funds often appoint active managers to generate ‘positive alpha’; that is, returns above a pure market return. Of course, alpha can be negative, meaning the portfolio has underperformed the market. The typical way of thinking about equity portfolios is to examine the beta and alpha components which together explain the entirety of a portfolio’s performance.

The alpha/beta distinction gives a superannuation fund investor a useful choice between adopting a fairly cheap passive approach to deliver equity beta returns or adding the costs of active management to the portfolio to (hopefully) deliver extra performance through alpha.

Enter factor investing. The insight at the heart of the factor trend is that a lot of alpha can actually be explained by some common factor risks that exist across stocks. The academic literature dates back to 1976 and the most well-accepted equity factors are Value, Quality, Size, Momentum, Dividend Yield and Low Volatility. Value and Low Volatility seem to be of particular interest to large superannuation funds at present. These investors are also exploring variations like factor combinations, timing factors and tax-managed factor approaches. There are key differences in the behaviour of factor risks between the Australian and global equity markets, which investors need to understand.

Challenging the traditional alpha/beta model

Factor investing challenges the traditional alpha/beta investment paradigm because it suggests that much of what has been labelled alpha is actually returns from simple factor bets (a type of beta). A factor-based equity approach can be constructed using straightforward ‘passive-like’ rules, offering transparency and control. They can be offered in a separate account or pooled fund form, including ETFs. These investment options offer superannuation funds the opportunity to outperform the market without the costs associated with active management. Avoiding the ‘black box’ of many active management approaches is also an attraction. Factor investing is a ‘thing’ because funds realise they have three choices – alpha/factor beta/traditional beta – not just two.

Our most recent factor research identified one of the common traps funds fall into; inadvertently introducing other risks into an equity portfolio while trying to construct a pure factor exposure. We also noted, perhaps counter-intuitively, that factor investing does not ring a ‘death knell’ for active equity managers who have been important components of the equity puzzle for many funds to date. Rather, factor investing provides an opportunity for active managers to clearly differentiate themselves from mere ‘factor providers’ and to negotiate generous risk budgets with their clients to deliver true alpha based on their research and unique insights.

For superannuation funds (and other investors) who embrace the factor trend, their job is twofold: to implement a well-constructed equity portfolio that reflects their factor convictions (and, as far as possible, nothing else); and to reposition their active manager partners (and internal management teams) to harvest alpha as a true complement and enhancement to the fund’s factor bets.

 

Raewyn Williams is Managing Director of Research at Parametric, a US-based investment advisor. Parametric is exempt from the requirement to hold an Australian Financial Services Licence under the Corporations Act 2001 (Cth) in respect of the provision of financial services to wholesale clients as defined in the Act and is regulated by the SEC under US laws, which may differ from Australian laws. This information is intended for wholesale use only and not for retail clients, as defined in the Act. Parametric is not a licensed tax agent or advisor in Australia and this does not represent tax advice. Additional information is available at www.parametricportfolio.com/au.

 

  •   17 November 2016
  •      
  •   

 

Leave a Comment:

banner

Most viewed in recent weeks

It’s time for LICs to die

A high-profile dividend cut and a prominent fund manager’s apology have reignited a long-running debate. If investors can access similar exposures more cheaply and efficiently elsewhere, what exactly is keeping LICs alive?

The retirement scorecard: how many of these questions can you answer?

From the maths of retirement, estimating spending and picking the right asset allocation to survive a poor decade, here are the questions every retiree – current or future – should be able to answer for themselves.

Testamentary trusts: Treasury has picked the wrong reading

A decades-old estate planning tool has survived one tax crackdown only to be caught by another. The surprise isn't who the reform is targeting, but who could end up paying the price for drafting choices made years ago.

How the typical Australian Family could save $844,350 in taxes

The value of a testamentary trust is not determined by wealth alone. Depending on circumstances, it can reduce the tax burden on inherited income, create efficiencies and help build intergenerational wealth.

The housing slide could become a crash

House prices are sliding across Australia, yet the most dangerous ingredient for a housing crash is still missing. If job losses surge amid growing economic risks, today's correction could become a historic property downturn.

Will investors be better or worse off under new housing tax changes?

Housing tax reforms have sparked warnings of market turmoil and promises of greater fairness. But after modelling nearly two decades of property data, the results suggest winners and losers may not be who many investors expect.

Latest Updates

SMSF strategies

Division 296: the initial moves to make before the windows close

What if the best superannuation strategy isn't about earning more, but acting before your options disappear? Several overlooked planning windows are narrowing, with consequences that can last for decades.

Planning

Avoid unnecessary CGT with this estate planning clause

A simple estate plan can create a ticking time bomb. One overlooked clause can pit spouses against children, delay inheritances, and potentially leave a family facing an unexpected tax bill worth hundreds of thousands of dollars.

Exchange traded products

The hidden trade-off in fixed income ETFs

Some investment trade-offs are immediately visible. Others are embedded in the way a portfolio is constructed. Understanding the difference may explain why similar-looking investments can produce surprisingly different results.

Retirement

The mortgage free retirement is fading

What happens when a generation reaches retirement carrying obligations previous generations largely avoided? New research suggests we may need to rethink both how much we need in retirement and what life could look like.

Retirement

The key question to inspire a confident and purposeful retirement

Most people spend decades planning for retirement. Far fewer plan for what happens when they get there. The difference may explain why so many find the transition harder and less fulfilling than expected, despite careful preparation.

Latest from Morningstar

Making the case for a 'good enough' portfolio

Some investors spend years chasing the perfect strategy. Others choose a path that’s simply good enough and move on. Which approach is more likely to deliver both better outcomes and a happier financial life over the long run?

Investment strategies

Is the US market as expensive as CAPE says?

Many investing ideas survive for decades. But that does not make them right. A famous valuation measure implies that US shares are dangerously expensive, but the evidence may point to a very different conclusion.

Sponsors

Alliances

  • ASA-Logo-RGB-ActiveGreen-web.png

© 2026 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.