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  • Writer's pictureStephen Boatman

What is Factor Investing?

Updated: May 24

Five investment factors of Factor Investing

Factor investing is a Nobel prize-winning investment strategy that targets specific factors within index funds. It’s our favorite long-term investment strategy and is based on the efficient market hypothesis. This strategy grew through an effort to fill in the gaps where the CAPM ratio fell short. Basically, the CAPM ratio tried to show that any return above the risk-free rate or what T-bills were paying was explained away by market risk. This meant that people were receiving a higher return above the risk-free rate because they were exposing themselves to further risk through their high-yield bond selections or more volatile equity selections. However, there were outliers in this model, and the increased risk exposure only accounted for around ⅔’s of the return premium. This meant that factors needed to be accounted for to attempt to make up the other ⅓ of the pie. If they could find these factors, they could more aggressively target them to find alpha. Alpha is a return above the expected benchmark return. Thanks to more research into this idea, they found five factors that explained away almost all the missing ⅓’d of the missing pieces. See factors in the chart above.

This video goes into more detail regarding the proof of factor investing’s historical outperformance and the reasoning behind the strategy.

How do we find exposure to these factors? We use Dimensional Fund Advisors, which has been in the factor space since 1981 and has a star-studded cast of advisors and multiple Nobel Prize winners assisting in their fund investing direction.

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