Building an Equity Factor Investing Strategy: A Practitioner's Roadmap for Strategic Decisions

Institutional investors and financial advisors are increasingly turning to equity factor based investing to enhance returns or manage risk. However, the proliferation of factor-based products—from traditional ETFs to alternative weighted mutual funds—has made the selection process far more complex. According to industry research, investment professionals recognize the value of factor strategies and plan to expand allocations in this space. Yet implementing these strategies effectively requires understanding some fundamental principles that often get overlooked in marketing materials.

Three Critical Decisions Before Implementation

Before selecting specific factor products, investment professionals must answer three fundamental questions that will shape the entire strategy. These decisions form the foundation of a sound equity factor investing approach.

The first question concerns security weighting methodology. How should individual holdings be weighted within a factor-focused portfolio? This seemingly technical choice has profound implications for factor exposure strength and implementation costs. Different weighting approaches deliver vastly different results—and different price tags.

The second question addresses implementation structure. Should the factor strategy operate as a rules-based index or through active management? Each approach has distinct advantages and trade-offs that must be evaluated against client objectives and cost tolerances.

The third question tackles portfolio construction complexity. If multiple factors could contribute to achieving investment goals, how should they be combined? The interaction between factors matters as much as the factors themselves, requiring a systematic approach to multifactor portfolio construction.

According to Doug Grim of Vanguard’s Investment Strategy Group, these distinctions matter far more than many practitioners realize. “A lot of marketing highlights the long-term performance of particular factors or strategies,” Grim noted in Vanguard’s research guide on equity factor based investing. “But the reality is that the performance of any factor-based product will likely vary over time and be difficult to predict. Understanding the nature of this cyclicality can help you set better expectations and make more informed allocation decisions.”

Weighing Your Options: The Role of Security Weighting in Factor Selection

The mechanics of how securities get weighted inside a factor product fundamentally determines the exposure quality and consistency. This is perhaps the most underappreciated decision in factor product selection.

Market-capitalization weighting offers the simplest approach. Traditional ETFs and mutual funds that screen for factor characteristics but then weight holdings by market cap provide modest factor exposure with lower costs and turnover. This method works well for investors seeking exposure to factors without disrupting overall market positioning.

Factor-sensitivity weighting represents the opposite extreme. Here, holdings are weighted based on their statistical sensitivity to the desired factor—whether that’s price momentum, earnings yield, or dividend rate. These products deliver substantially higher and more consistent factor exposure, making them suitable for investors with a deliberate factor tilt objective. The trade-off is higher turnover and potentially elevated costs.

Long-short strategies occupy a third category. These vehicles buy securities scoring highest on desired metrics while simultaneously shorting securities that score lowest. The goal is isolating pure factor exposure while eliminating overall market movements (market beta). However, short-selling requires leverage and incurs significant costs, making these approaches the most expensive option.

The choice between these approaches requires honest self-assessment: How much factor exposure makes sense for the portfolio? What price—measured in fees, taxes, and trading costs—justifies that exposure? Will the chosen approach maintain consistent factor exposure over time, or does methodology risk causing unintended drift? These considerations drive the weighting methodology decision.

Choosing Your Implementation Method: Index-Based Versus Active Factor Strategies

While all factor tilts represent active portfolio decisions, the execution methodology varies significantly. Investment professionals can choose between index-driven approaches and active management—each with distinct characteristics.

Index-based factor products offer high transparency and typically lower costs. The investment methodology gets documented by the index provider and remains consistent over time. The active decision embedded in index design—which factors to include, how to weight them, how often to rebalance—remains fixed and transparent.

Active factor products fall into two subcategories. The first, active selection, involves managers attempting to add value beyond the base factor exposure. These managers make discretionary stock picks, attempting to capture alpha in addition to the targeted factor return. This approach mirrors traditional active management but with a factor foundation.

The second approach, active implementation, maintains consistent factor exposure while using trading flexibility to reduce costs and minimize unintended drift. Rather than mechanically rebalancing on predetermined dates, managers can adjust holdings when they observe meaningful changes in factor characteristics. This approach preserves factor purity while improving execution efficiency.

These distinctions matter considerably. Active selection introduces stock-picking risk atop factor risk. Active implementation focuses purely on consistent factor delivery with improved cost management. The choice affects both expected returns and actual risk profile.

Diversifying Across Factors: When and How to Combine Multiple Factor Strategies

Single factors rarely perform consistently across all market environments. Value strategies excel during certain periods but underperform in others. Low-volatility approaches reduce downside risk but often lag during bull markets. This inherent cyclicality prompts many professionals to consider combining multiple factors within a single portfolio.

Two distinct approaches exist for constructing multifactor portfolios. The top-down method involves assembling separate single-factor products and manually blending them. This approach gives investment professionals complete control: selecting which factors to include, choosing asset managers for each factor sleeve, determining weighting schemes, and setting allocation levels.

The bottom-up method takes a different path. A single product uses a comprehensive evaluation process, assessing each security across all desired factors simultaneously. A stock need not excel in every factor—moderate strength across multiple factors may prove sufficient for inclusion. This approach often results in lower turnover because selling isn’t triggered by weakness in a single factor if the security remains attractive on other dimensions.

Research suggests bottom-up multifactor strategies may deliver superior long-term results for buy-and-hold investors by reducing unnecessary turnover and avoiding factor-inadvertent tilts. The systematic evaluation of securities across all factors simultaneously ensures the portfolio doesn’t accidentally develop unintended exposures that offset targeted factor benefits.

Managing Expectations: Why Factor Performance Varies Across Market Cycles

Perhaps the most important lesson from equity factor investing research involves managing expectations around performance variability. There exists no universally superior factor or factor combination that performs well across all market conditions. Performance cycles—sometimes extended—are built into factor strategies.

This reality has important implications. Attempting to time factor rotations—betting on which factors will outperform over the next year or two—has proven notoriously difficult. Results vary substantially among different products pursuing similar factor strategies, underscoring why careful product evaluation remains essential.

Several principles should guide long-term factor investing decisions. First, costs matter significantly. Implementation costs, trading expenses, taxes, and expense ratios all impact net returns—the only returns that matter. Making decisions based on expected net returns (not gross returns before costs) ensures realistic performance expectations.

Second, maintaining discipline proves crucial. Chasing past performance or abandoning factors during underperformance periods typically destroys value. Clear goals, diversification, cost control, and commitment to the strategy form the foundation for successful long-term investing, whether using factor-based approaches or not.

The comprehensive framework outlined in research from investment professionals at Vanguard and other institutional managers provides practitioners with systematic guidance for equity factor based investing decisions. By methodically addressing weighting methodology, implementation approach, and factor combination strategy, investment professionals can construct factor portfolios aligned with specific client objectives while maintaining realistic performance expectations throughout market cycles.