Smart beta and factor investing are two terms often used interchangeably. These are both investing strategies that investors may use. However, there are various factors that differentiate both these investing strategies. Before understanding how they differ, it is critical to look at what each of these is.
What is Smart Beta Investing?
Smart beta investing is an investment strategy that allows investors to benefit from active and passive investing strategies. It combines both of these aspects to allow investors to maximize their gains. Smart beta portfolios are theoretically efficient compared to other portfolios. They try to strike a balance between the efficient market hypothesis and value investing.
Smart beta investing seeks to achieve several objectives for investors. These may include low-risk investments, highly diversified portfolios with low cost, or alpha. This approach to investing applies to all well-known asset classes, including stocks, commodities, bonds, etc. The smart beta investing strategy stems from the work of Harry Markowitz through the modern portfolio theory.
What is Factor Investing?
Factor investing is another strategy used by investors. Unlike smart beta investing, factor investing involves investing in assets based on predetermined factors. Each investor will specify or decide on which attributes they want their investments to match. Once they do so, they can choose investments that relate to those factors. These factors will also decide whether the investments are successful in achieving investors’ goals.
There are two categorizations of factors that investors may consider during factor investing. These include macroeconomic and style factors. Macroeconomic factors seek to describe the risks associated with several asset classes. Style factors, on the other hand, explain the risks and rewards related to individual asset classes. Factor investing originates from the work of Fama and French as an asset pricing model.
What are the differences between Smart Beta and Factor Investing?
There are several characteristics that define and differentiate smart beta and factor investing. Both strategies have some commonalities, which can make them similar. However, there are some features that can separate them from each other as well. For investors, it is crucial to understand the differences between both of these to achieve their objectives.
Smart beta investing is a strategy that works with all popular asset classes. This approach to investing may emphasize achieving alpha, high diversification, or low-risk investments. For investors, it can help in building a portfolio with lower risks compared to traditional investing strategies. As mentioned, smart beta investing includes the advantages of both passive and active investing.
Smart beta investing follows specific rules which are also transparent. However, it seeks to identify ways in which investors can capitalize on any inefficiencies in the market. There are several investment factors that smart beta investing follows. These include value, quality, small size, momentum, and minimum volatility.
Factor investing, on the other hand, involves targeting specific return drivers across asset classes. As mentioned, these drivers may include macroeconomic and style factors. Each of these factors consists of various other investment factors within them. Through these, investors can achieve several objectives. These may include reduced volatility, diversification, and better returns.
Conclusion
Smart beta and factor investing are two common investment strategies that may confuse investors. Smart beta investing follows value investing and efficient market hypothesis. It involves a combination of active and passive investing strategies. On the other hand, factor investing focuses on achieving objectives that may come in the form of style or macroeconomic factors.
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