Are you having a hard time trying to decide between active and passive investing? Each approach has its merits, but neither is perfect. If you want to outpace the market without taking on the risks of stock picking, you may want to consider an alternative strategy that was developed by Nobel Prize-winning economists. It's called factor investing, and it has outperformed the market for extended periods in the past.

Active versus passive investing

Stock picking is difficult and time-consuming, and it might put you in some risky positions when things don't go according to plan. On the other hand, buying index funds is a great way to mitigate those risks, but it's never going to provide the same upside potential that actively-managed portfolios can deliver.

Luckily, there's a hybrid strategy that can provide benefits from each style. You may see references to "rules-based passive investing" when reading about certain ETFs and mutual funds. These funds hold a large number of stocks from a given index, but they only hold stocks that meet specific predetermined criteria. These criteria can encompass all sorts of characteristics, including market capitalization, growth, momentum, valuation, quality, volatility, and liquidity.

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Factors to beat the market

Factor investing is a type of rules-based passive investing that only targets stocks displaying certain characteristics, or factors, that are shown to increase long-term performance. Theoretically, a portfolio composed entirely of stocks with these factors should outpace the market long term. This can be done without incurring the time or expenses needed to pick individual stocks, which provides an opportunity to enhance returns without all the additional effort.

Economists have spent the past 50 years trying to nail down which factors are the strongest determinants of stock performance. Famous work by Eugene Fama and Kenneth French in the 1990s identified smaller market caps and lower price-to-book ratios as strong indicators that a stock would outpace its peers in the long term. Thus, a small-cap company with low valuation multiples is likely to deliver better returns than a large-cap growth stock with a high valuation, according to their work.

Subsequent studies have expanded upon these findings, and newer strategies commonly include momentum, low volatility, and quality (e.g., profitability, cash flow, and financial health) among the factors that are likely to improve performance. Factor investing strategies don't completely abandon large-cap stocks or companies with high valuations. However, weighting in these portfolios is guided by factor scores, meaning stocks that grade the best tend to be the largest holdings. This can be contrasted with market-weighted indexes, in which the largest companies are the biggest holdings. This means that factor-based allocations are more skewed toward smaller companies than you would expect in most passive strategies.

How to implement a factor investing strategy

If you're managing a large enough portfolio, you can probably just run a stock screen for a handful of factors, and then allocate based on the results of those screens. However, that can get complicated, and it definitely requires a large sum of capital to make it work.

Factor ETFs are a simpler solution for most investors, and there are numerous funds in this category. One of the most popular factor ETFs is the iShares MSCI USA Multifactor ETF (NYSEMKT: LRGF) with nearly $1 billion in assets under management and an average daily trading volume of just under $4 million. This fund holds large and mid-cap U.S. equities based on quality, value, momentum, and small size. It's sufficiently liquid and has a low expense ratio, both of which are great for investors. The fund's cousin, the iShares MSCI Intl Multifactor ETF (NYSEMKT: INTF) replicates that strategy for international stocks. The Vanguard U.S. Multifactor ETF (NYSEMKT: VFMF) takes a slightly different approach across a larger investable universe, though it's a smaller fund with less liquid shares.

A final note of caution

Unfortunately, there's no magic bullet for the stock market, and factor investing is no exception. It's fine to learn about these strategies and implement them where appropriate, but many factor allocations have lagged the S&P 500 during the most recent bull market. The research that spawned factor investing was based on data from very different market conditions, and there's no guarantee that past results are reliable predictors of future returns. Stay vigilant as you allocate based on factors, and recognize the conditions that would make value and quality stocks thrive.

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