To understand factor based investing, one must first understand the concept of Smart Beta. What do we understand by Smart Beta? Many funds that follow smart beta strategies combine elements of active and passive investing. Some seek to outperform broad market indexes, some focus on generating income, and others seek to reduce volatility and risk. Smart Beta is all about adopting a passive approach to investing but adding elements of active strategy to it. This is the core of understanding Factor based investing (FBI). While the emergence of smart beta funds is a recent phenomenon, the underlying investment philosophy has been around for decades. These funds rely on factors. A factor is simply an attribute such as the quality or size of a company that may help explain risk and returns.

What smart beta funds do is to track indexes that are constructed around one or more factors. For example, a fund that is based on the quality factor would track an index that is composed of companies that generate superior profits, strong balance sheets, and stable cash flows. Similarly another approach to smart beta can be based on the size factor. Small-cap stocks have historically outperformed large-cap stocks, although leadership can shift over shorter periods. The original seeds of factor-based investing were sown with the introduction of the capital asset pricing model (CAPM) in the 1960s. This is the model for pricing capital assets based on risk and is considered to be the first factor based model. CAPM uses market exposure to explain a stock’s performance relative to its index. The remainder of a stock’s performance was attributed to company-specific factors. Over the past few decades, investment professionals have identified a variety of such factors and exposures that have outperformed the market or reduced portfolio risk.