Factor investing has transformed how institutional and individual investors think about building portfolios. Rather than simply buying the market, factor investors target specific characteristics that have historically driven returns. In this guide, we will explain what factors are and how you can use them in your investment strategy.
What is Factor Investing?
Factor investing is an investment approach that targets specific drivers of returns across asset classes. These factors are measurable characteristics that explain why certain stocks outperform others over time. By tilting your portfolio toward these factors, you aim to capture excess returns beyond what the broad market offers.
The simple version: Factor investing is like fishing where the fish are. Instead of casting your net everywhere, you focus on areas where research has shown fish (returns) tend to gather.
The History of Factor Investing
Factor investing has its roots in academic research. In the 1960s, the Capital Asset Pricing Model (CAPM) introduced the idea that market exposure (beta) explains stock returns. Then in 1992, Eugene Fama and Kenneth French showed that two additional factors, size and value, also explained returns. This three-factor model revolutionized investing.
Since then, researchers have identified additional factors that have stood the test of time and rigorous analysis. Today, factor investing is a multi-trillion dollar approach used by the world's largest asset managers.
The Major Investment Factors
1. Value Factor
Value investing targets stocks that appear cheap relative to their fundamentals. These stocks have low prices compared to their earnings, book value, or cash flows.
Value Factor Example
Consider two companies with similar earnings of $5 per share:
- Company A trades at $50 (P/E ratio of 10)
- Company B trades at $100 (P/E ratio of 20)
A value strategy would favor Company A because you are paying less for each dollar of earnings. Historically, buying baskets of these undervalued stocks has generated excess returns.
2. Momentum Factor
Momentum investing buys stocks that have performed well recently and avoids stocks that have performed poorly. The idea is that trends tend to persist in the short to medium term.
- Time frame: Typically looks at returns over the past 3 to 12 months
- Why it works: Investor behavior causes prices to underreact to news initially, then continue trending
- Risk: Momentum can reverse sharply during market turning points
3. Quality Factor
Quality investing focuses on companies with strong fundamentals. These companies typically have:
- High profitability (return on equity, return on assets)
- Stable earnings growth
- Low debt levels
- Strong cash flows
Quality stocks tend to be more resilient during market downturns and compound wealth steadily over time.
4. Size Factor
The size factor, also called the small-cap premium, is based on the observation that smaller companies tend to outperform larger companies over long periods. Small-cap stocks are riskier but offer higher potential returns.
Important note: The small-cap premium has been less consistent in recent decades, especially in the US market. Many factor investors now combine size with other factors like value or quality for better results.
5. Low Volatility Factor
Contrary to traditional finance theory, stocks with lower volatility have historically delivered similar or better returns than high volatility stocks. This anomaly exists because:
- Investors often overpay for exciting, volatile stocks
- Boring, stable companies are underappreciated
- Lower drawdowns allow for better compounding
6. Dividend Yield Factor
Dividend-focused investing targets stocks that pay above-average dividends. These companies often share characteristics with value and quality stocks, providing income while you wait for capital appreciation.
How to Implement Factor Investing
Option 1: Single-Factor ETFs
The simplest approach is buying ETFs that target one specific factor:
- Value ETFs track indexes of undervalued stocks
- Momentum ETFs hold recent outperformers
- Quality ETFs focus on financially strong companies
- Small-cap ETFs invest in smaller companies
Option 2: Multi-Factor ETFs
Multi-factor ETFs combine several factors in one fund. This provides diversification across factors, since different factors perform well at different times.
Multi-Factor Portfolio Example
A balanced multi-factor approach might combine:
- 25% Value factor exposure
- 25% Momentum factor exposure
- 25% Quality factor exposure
- 25% Low volatility factor exposure
This diversification helps smooth returns because when value underperforms, momentum might outperform, and vice versa.
Option 3: Factor Tilts
Instead of replacing your core portfolio, you can tilt toward factors by adding factor ETFs alongside your broad market index funds.
Factor Performance Through Market Cycles
Different factors perform differently depending on economic conditions:
- Value: Tends to outperform during economic recoveries and periods of rising interest rates
- Momentum: Works well in trending markets but can reverse sharply at turning points
- Quality: Outperforms during economic uncertainty and market stress
- Low Volatility: Provides protection during market downturns
- Size (Small-Cap): Typically outperforms early in economic expansions
Risks and Challenges of Factor Investing
- Factor timing is difficult: Predicting which factors will outperform is nearly impossible
- Long periods of underperformance: Any factor can underperform the market for years at a time
- Crowding risk: As more money flows into factor strategies, premiums may shrink
- Higher costs: Factor ETFs typically charge more than plain index funds
- Complexity: Understanding and sticking with factor strategies requires education and discipline
Warren Buffett's secret: Research has shown that much of Berkshire Hathaway's outperformance can be explained by exposure to value, quality, and low volatility factors, plus the use of leverage. Factor investing provides a systematic way to capture similar exposures.
Best Practices for Factor Investors
- Diversify across factors: Do not bet everything on one factor
- Have a long time horizon: Factor premiums are not guaranteed in any short period
- Keep costs low: The factor premium is small, so high fees can eat it up
- Stay disciplined: Do not abandon factors during periods of underperformance
- Rebalance regularly: Maintain your target factor exposures over time
Analyze Your Factor Exposures
Pro Trader Dashboard helps you understand your portfolio's characteristics and track performance across different market conditions. See how your investments align with various factor strategies.
Summary
Factor investing offers a systematic way to target specific drivers of returns that have been validated by decades of academic research. By understanding factors like value, momentum, quality, and low volatility, you can build a more informed investment strategy.
Remember that factor investing is not a get-rich-quick scheme. It requires patience, discipline, and a long-term perspective. But for investors willing to stay the course, factor tilts can potentially improve risk-adjusted returns over time.
Want to learn more? Explore our guide on smart beta ETFs or discover strategic asset allocation principles.