What is factor investing? Factor investing generally means building a portfolio tilted toward specific characteristics — like value, size, quality, or momentum — that have historically been associated with different return and risk patterns, rather than simply holding a broad market-cap-weighted index. It's a more targeted approach that carries its own distinct risks compared to broad diversification.

Article Summary

  • Common factors include value, size, momentum, quality, and low volatility, each based on historical academic research into return patterns.
  • Factor investing tilts a portfolio toward these characteristics rather than replacing broad diversification entirely.
  • Historical factor premiums have not been consistent in every period, and past patterns are not a guarantee of future performance.

"In investing, what is comfortable is rarely profitable."

Robert Arnott

Most people's first exposure to investing is through broad, market-cap-weighted index funds — essentially owning a slice of the whole market as it's sized today. Factor investing takes a more targeted approach, deliberately tilting a portfolio toward specific, historically studied characteristics that have been associated with different risk and return patterns over long periods. It's a more advanced strategy, and one that comes with its own trade-offs worth understanding before adopting.

What a "Factor" Actually Means

In investing research, a "factor" is a measurable characteristic of a stock — like being relatively cheap compared to earnings (value), being a smaller company (size), or having positive recent price trends (momentum) — that has historically been associated with different average returns compared to the broad market over long study periods.

Factor investing funds generally screen and weight holdings based on these characteristics, rather than simply weighting by total market value, aiming to capture the historical patterns associated with the chosen factor or combination of factors.

Common Factors Used in Practice

Widely studied factors include value (relatively cheap stocks based on measures like price-to-earnings), size (smaller companies), momentum (stocks with recent positive price trends), quality (companies with strong balance sheets and profitability), and low volatility (stocks with historically smaller price swings).

Some funds target a single factor, while others combine multiple factors, aiming to diversify across different historical return drivers rather than concentrating in just one.

The Evidence, and Its Limits

Academic research spanning long historical periods has associated certain factors with, on average, different returns compared to the broad market, which is the foundation for factor investing strategies. However, these patterns have not held consistently in every shorter time period, and some factors have gone through extended stretches of underperformance relative to the broad market.

Past factor performance, like past performance of any investment strategy, is not a reliable guarantee of future results, and factor investing generally involves higher complexity and sometimes higher costs than simple broad-market index investing.

Should You Consider Factor Investing?

For many investors, a simple, broadly diversified, low-cost index fund remains a reasonable default, and factor investing is generally considered a more advanced strategy best adopted with a clear understanding of the specific factors involved and realistic expectations about the uncertainty of future outperformance.

If you do explore factor funds, comparing expense ratios against simpler index alternatives, and understanding that factor tilts can underperform the broad market for extended periods, are both important parts of setting realistic expectations.