Factor Investing Explained: How Smart Beta Strategies Actually Generate Outperformance

Factor investing used to be just an academic theory, and now it’s an essential part of real-life financial decisions made by investors on a daily basis. 

Simply put, factor investing seeks to explain and capture the drivers of investment returns beyond simple market exposure. 

This approach doesn’t just assess financial assets based on their market capitalization, but also focuses on special characteristics, or factors, that have historically delivered high returns. 

Smart beta strategies apply these insights systematically and rules-based.  Supporters feel this approach delivers better results than traditional investing, while critics point out that the increased complexity isn’t beginner-friendly. 

In this article, we’ll explain the practice and analyze how effective beta strategies actually are.  We will also assess whether they can sustain such performance over prolonged periods. 

The Origins of Factor Investing and Smart Beta

Factor investing originates from financial economics, particularly the study of what drives asset returns. 

According to experts such as those at CryptoManiaks, the primary way to determine expected returns is to evaluate the risks involved.  The riskier the assets, the loftier the reward. 

In the early 1990s, the economists Eugene Fama and Kenneth French introduced a more complex model stating that three major factors affect returns.  Company size and evaluation are as important as the risk itself in determining potential profits. 

Over time, further research expanded this framework to include other factors.  The most important of these are momentum, investment behavior, and profitability.  As time went by, the investors had to deal with an ever-growing set of metrics. 

Smart beta emerged as an advancement of the theories we mentioned and as a way to put them into practice.  The asset manager began designing index-like apps that systematically captured factor exposure while remaining transparent and rules-based. 

What Are Investment Factors?

Investment factors are specific characteristics of securities that are associated with high long-term returns.  These factors are long-studied and perceived across different markets and assets. 

Experts from CryptoManiaks claim that they apply to both crypto and traditional assets. 

• Value refers to stocks that appear inexpensive relative to earnings, book value, or cash flow.  Value assets tend to outperform growth stocks in the long run.  Investors tend to overreact to short-term problems and undervalue an asset’s turnaround potential.
• Size captures the tendency of smaller companies to outperform larger ones over long horizons. Small-cap assets tend to be riskier, but their higher returns over the long run compensate for this risk.
• Momentum refers to how well the asset has performed recently.  It usually shows that it will continue to perform comparably in the near term, but it doesn’t say much about the long term.
• Low volatility challenges traditional finance theory.  It shows that assets that aren’t volatile and therefore not risky could also deliver value and profit.  These profits are often similar to those of risky assets, thus showing that risk isn’t always tied to gains.
• Quality focuses on a company’s earnings stability and operational efficiency.

How Smart Beta Strategies Are Constructed

Smart beta strategies differ from traditional indexes based on how they select securities.  They rely on predefined rules tied to factor exposure.  The rules are then used to rank stocks and other assets based on actor metrics and select those with the stronger signals. 

Some strategies use alternative weighting schemes, such as equal weighting, fundamental weighting, or volatility weighting.  Others apply factor screening to tilt the portfolio toward the factor they consider most important, while maintaining balance when possible. 

Smart beta strategies sometimes focus on a single factor, while others use multiple factors to build the portfolio.  Single-factor strategies are more straightforward and more transparent, but can underperform for a long time. 

A multi-factor strategy, however, smooths returns but is more complex and not always suited to novice investors. 

Another key decision when using smart beta strategies is to adopt a factor tilt, increasing exposure relative to a benchmark or factor concentration that heavily emphasizes stocks with the strongest factor signals. 

Why and How Smart Beta Can Generate Outperformance

Smart beta strategies generate outperformance by systematically capturing factor premia.  There are two main reasons why this is the case. 

The main one is about risk.  Some factors represent additional risks that investors are reluctant to bear.  For instance, small-cap stocks may be more vulnerable to economic downturns. 

Investors, therefore, expect higher returns in exchange for holding these assets longer during difficult market conditions. 

The second reason is behavioral.  Investors don’t always make their decisions based on rational reasons and tend to get scared during market downturns or to invest too heavily in a single asset based on short-term trends. 

There’s no metric that could account for this behavior, since, in the end, the decisions are made by people. Combining multiple factors can yield the best outcomes by preventing reliance on a single metric. 

Because factors perform differently across economic cycles, multi-factor portfolios can offer more stable performance and reduce drawdowns during unfavorable market regimes. 

The Risks and Limitations of Factor Investing

 Despite its scientific basis, factor investing doesn’t always guarantee outperformance.  One of the biggest challenges for investors is that the markets are also almost always cyclical. 

Factors can underperform for many years before bouncing back, and investors aren’t always ready to wait. 

There’s also a model risk to be aware of.  Depending on the methodology they use, investors may get very different results, as factor definitions vary across providers.  Additionally, when a factor strategy becomes popular, markets can become crowded, thereby reducing profits. 

Costs are another consideration that should be taken seriously when investing, as they cut into profits, especially for investors working with smaller sums and tighter profit margins. 

Smart beta strategies are challenging to execute, so they typically have much higher fees than traditional investing.  Investors should also be aware of tracking error, the risk that their factor strategy will deviate significantly from the broader market. 

Real-World Applications of Smart Beta

At this point, smart beta strategies are most widely used with exchange-traded funds (ETFs).  These products are also more transparent, more liquid, and less costly than traditional financial assets, such as stocks or bonds. 

Institutional investors, such as pension funds and endowments, have already started using ETFs. 

They see it as a way to enhance long-term profits, but also as a way to show they are advanced and forward-looking, and willing to embrace the latest industry trends.  Investors appreciate such efforts even when they are skeptical of risk. 

For individual investors, smart beta is often used as a satellite allocation alongside traditional options.  That way, it provides diversification and allows investors to gradually move to a beta strategy, ensuring it outperforms the other investments they are making. 

To Sum Up

Factor investing and smart beta strategies are an alternative to traditional index investing. 

They are grounded in academic research and provide new explanations of why and how an asset will perform in the market.  This often means they’ll deliver higher profits than the alternatives, especially in the long term. 

Factor investing also has flaws, as does any investment approach.  It can have years of underperformance; the question of which performance factors to use remains open; and there are additional costs investors should take into account.