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.

 


 

Leave a Comment:

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Latest Updates

Retirement

The best way to get rich and retire early

This goes through the different options including shares, property and business ownership and declares a winner, as well as outlining the mindset needed to earn enough to never have to work again.

Shares

Boom, bubble or alarm?

After a stellar 2025 to date for equities, warning signs - from speculative froth to stretched valuations - suggest the market’s calm may be masking deeper fragilities. Strategic rebalancing feels increasingly timely.

Property

A perfect storm for housing affordability in Australia

Everyone has a theory as to why housing in Australia is so expensive. There are a lot of different factors at play, from skewed migration patterns to banking trends and housing's status as a national obsession.

Economy

Which generation had it toughest?

Each generation believes its economic challenges were uniquely tough - but what does the data say? A closer look reveals a more nuanced, complex story behind the generational hardship debate. 

Shares

Is the iPhone nearing its Blackberry moment?

Blackberry clung on to the superiority of keyboards at the beginning of the touchscreen era and paid the ultimate price. Could the rise of agentic AI and a new generation of hardware do something similar to Apple?

Fixed interest

Things may finally be turning for the bond market

The bond market is quietly regaining strength. As rate cuts loom and economic growth moderates, high-quality credit and global fixed income present renewed opportunities for investors seeking income and stability. 

Shares

The wisdom of buying absurdly expensive stocks (or not!)

Companies trading at over 10x revenue now account for over 20% of the MSCI World index, levels not seen since the dotcom bubble. Can these shares create lasting value, or are they destined to unravel?

Sponsors

Alliances

© 2025 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.