Factor Investing

Factor investing is an investment approach that selects securities based on attributes (factors) historically associated with higher returns or different risk exposures. By targeting broad, persistent drivers of returns, factor investing seeks to enhance diversification, manage risk, and potentially generate above-market performance.

Key takeaways

• Factors are characteristics that help explain asset returns across and within asset classes.
• Common factor categories include macroeconomic factors (inflation, GDP growth) and style factors (value, size, momentum, quality, volatility).
• Smart beta and multi-factor funds are common ways investors implement factor strategies.

Types of factors

• Macroeconomic factors: Broad risks that affect many asset classes (e.g., inflation, GDP growth, unemployment).
• Style (or risk) factors: Characteristics that explain return differences within an asset class (e.g., growth vs. value, market capitalization, momentum).
• Micro factors and residual risk: Company-specific attributes such as credit quality, liquidity, and idiosyncratic risk not captured by broader factor models.

Why use factor investing

• Improves diversification by targeting drivers of returns rather than relying solely on asset-class allocations (e.g., 60/40 portfolios can still move together under certain conditions).
• Helps manage and make explicit the risks in a portfolio.
• Can be used to pursue systematic excess returns by tilting toward historically rewarded factors.

For beginners, focusing on readily available attributes—style (growth vs. value), size (large cap vs. small cap), and risk (beta/volatility)—is a practical way to get started.

Common factor definitions and how they’re measured

• Value — Targets stocks priced cheaply relative to fundamentals (metrics: price-to-book, price-to-earnings, dividend yield, free cash flow).
• Size — Captures the historical tendency for small-cap stocks to outperform large caps (measured by market capitalization).
• Momentum — Based on the tendency for recent winners to continue outperforming; typically measured using relative returns over 3 to 12 months.
• Quality — Focuses on companies with strong balance sheets and earnings stability (metrics: return on equity, debt-to-equity, earnings variability).
• Low volatility — Pursues stocks with lower price variability, which research shows can deliver attractive risk-adjusted returns (measured by standard deviation or beta over 1–3 years).

Example: Fama–French three-factor model

The Fama–French model expands on the Capital Asset Pricing Model (CAPM) by adding two style factors to market risk:
* SMB (Small Minus Big) — captures the size premium (small-cap outperformance).
HML (High Minus Low) — captures the value premium (high book-to-market stocks outperform).
Market excess return — the portfolio’s return minus the risk-free rate.

These three factors together explain more variation in stock returns than market risk alone.

Implementation and practical notes

• Smart beta funds and factor ETFs are common, low-cost ways to gain exposure to specific factors or combinations of factors.
• Factor exposures can be combined (multi-factor) to diversify sources of return and reduce reliance on any single driver.
• Factor effectiveness can vary over time and by market environment; monitoring, rebalancing, and understanding implementation costs are important.

Bottom line

Factor investing organizes securities by systematic attributes tied to returns and risk, offering a framework to improve diversification and pursue enhanced long-term outcomes. Start simple—by tilting toward widely available factors like value, size, momentum, quality, or low volatility—and consider multi-factor or smart beta implementations as sophistication grows.