Factor investing targets specific characteristics that academic research has shown to drive excess returns over the long term.
The Main Factors
| Factor | Description | How It Works |
|---|
| Size | Small-cap stocks outperform large-cap | Small companies have higher growth potential |
| Value | Cheap stocks outperform expensive ones | Low price-to-book stocks have higher returns |
| Momentum | Recent winners continue to win | Stocks that went up keep going up |
| Quality | High-quality companies outperform | Profitable, stable, well-managed companies |
| Low volatility | Low-risk stocks outperform high-risk | Defensive stocks have higher risk-adjusted returns |
Factor Performance History
| Factor | Annual Excess Return (US, 1927-2023) |
|---|
| Size (small caps) | ~2-3% |
| Value | ~3-5% |
| Momentum | ~8-10% (but high turnover) |
| Quality | ~2-4% |
| Low volatility | ~1-2% |
Size Factor
| Aspect | Details |
|---|
| Definition | Small market capitalisation companies |
| Rationale | Higher risk, less analyst coverage, higher growth |
| ETF examples | IUSN (iShares World Small Cap), AVUS |
| Risks | Higher volatility, less liquidity |
Value Factor
| Aspect | Details |
|---|
| Definition | Low price relative to fundamentals (P/B, P/E, P/S) |
| Rationale | Market overreacts to bad news |
| ETF examples | VVAL (Vanguard Global Value Factor) |
| Risks | Value traps (cheap for a reason) |
Momentum Factor
| Aspect | Details |
|---|
| Definition | Stocks with strong recent returns |
| Rationale | Investors underreact to new information |
| ETF examples | MTUM (iShares MSCI USA Momentum Factor) |
| Risks | High turnover, crash risk, tax inefficient |
Quality Factor
| Aspect | Details |
|---|
| Definition | High profitability, stable earnings, low debt |
| Rationale | Quality companies compound better |
| ETF examples | QUAL (iShares MSCI USA Quality Factor) |
| Risks | Can be expensive (high P/E) |
How to Implement
| Method | How |
|---|
| Factor ETFs | Single ETF targeting one factor |
| Multi-factor ETFs | One ETF targeting several factors |
| Smart beta funds | Rule-based index with factor tilts |
| Direct stock selection | Build your own factor portfolio |
Multi-Factor Approach
| Combination | Why |
|---|
| Value + Momentum | Value captures long-term, momentum captures short-term |
| Quality + Low Volatility | Defensive combination |
| Size + Value | Small-cap value has strongest historical returns |
Bottom Line
Factor investing targets specific return drivers: size, value, momentum, quality, and low volatility. Each factor has strong academic backing and historical evidence. Multi-factor approaches reduce reliance on any single factor. Factor ETFs make implementation simple for individual investors. Factor premiums can underperform for extended periods (value underperformed for a decade after 2007). Patience is essential.
This content is for educational purposes only. Not financial advice. Do your own research before investing.