An Overview of Factor Investing

Factor investing involves buying stocks with certain characteristics, including value, momentum, size, low volatility and quality in an attempt to find winning stocks.

Factor Investing: What Is It?

Factor investing is an investment strategy that selects stocks based on certain fundamental attributes or price return-based patterns. Unlike many indices or portfolios that hold and weigh stocks based on their market capitalization, factor-based approaches utilize empirically tested investment factors such as size, value, momentum, quality and low volatility. These factors have been proven to produce greater long-term returns when compared to the overall market.

According to the book, “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” investment factors need to have the following five features in order for them to have a strong likelihood to continue to produce a return premium in the future.

Persistent: The factor needs to have worked over very long periods of time.
Pervasive: The factor should work in different markets and asset classes.
Robust: The factor should show effectiveness using different definitions or metrics.
Investable: The factor still works even after trading and other implementation costs.
Intuitive: The performance generated by the factor should make sense through either a risk or behavioral-based explanation.

Most factor investing approaches are considered systematic (also known as quantitative investing) because the selection of the stocks is not being performed by a human analyst or investor. Rather, models are built so that they score and rank stocks by one or many factors, and portfolios are constructed automatically without subjectivity, emotion or human bias.

Factor investing has gained in popularity over the past decade as major investment management firms, banks and brokerages have embraced factor-based investing and rolled out ETFs and other products that incorporate factors.

Next, we’ll look at the major factors.

The Major Investing Factors

When it comes to factor investing, there are a handful of factors that stand out above the crowd. These factors were identified and tested empirically over long periods of time to show that they produce an excess return.

Value: Data shows that buying stocks that are cheap based on book equity, earnings or cash flow have historically produced returns above the market. Investors tend to systematically underprice value stocks due to concerns or risks with their underlying businesses, and as the businesses improve or stabilize, the stocks of these companies tend to revert higher. (See our Value Investing Article for more details on the value factor)
Momentum: Research shows that stocks exhibiting strong intermediate term price performance (3 to 12 months) tend to continue to perform well going forward. Over a market cycle, stock leadership changes as investors gravitate toward specific sectors, industries and certain stocks, and momentum investing seeks out the best performing stocks over time. (See our Momentum Investing Article for more details on the momentum factor)
Size: Long-term data shows that small cap stocks outperform large stocks. While this premium in the market has been fading over the past few decades, smaller companies tend to be riskier and more impacted by economic contractions and expansions. Investors tend to receive a higher return by investing in small caps due to their higher risk. Within the small cap space, small cap value stocks have been one of the best performing groups of stocks when it comes to style and size. (See our Small Cap Value Article for more details on small cap value stocks)
Low Volatility: The idea of higher risk producing a higher return gets flipped upside down with low volatility investing, with research showing that low volatility stocks outperform the market. Stocks that decline less in market downturns don’t need to recover as much once prices revert back up. This is one of the key reasons why low volatility stocks give investors superb risk-adjusted returns. (See our Low Volatility Investing Article for more details)
Quality: Many investors look for high quality stocks with strong fundamentals (i.e. low debt, consistent earnings, high return on equity and return on capital), but the healthiest companies also tend to demand a premium valuation in the market. For investors looking to buy quality companies, it may be best to couple their strategy with value investing techniques and wait for quality companies to go on sale. As Warren Buffet once said, “Whether we’re talking about socks or stocks, I like buying quality merchandise when it is marked down.” (See our High Quality Investing Article for more details)

Like all forms of active investing, factor investing isn’t for everyone, and investors who utilize factors should understand both the pluses and the minuses. Next, we explore the realities of factor investing and how investors can get the most of our factors over time.

Factor Investing Considerations

Selecting stocks based on investment factors is an active form of investing, and any time you actively select stocks in an attempt to outperform the market, there are important considerations to keep in mind.

The first important point is that factors don’t always work, and they can go through long periods of relative underperformance vs. a diversified market cap weighted portfolio. A portfolio of value stocks may go through a multi-year period of lackluster returns before an investor sees improved relative performance. If a factor worked all the time, its excess return would go away because investors would crowd into the factor and destroy any premium that exists. The fact that they don’t always work is why factor investing works long-term -- investors move in and out of factors based on performance and what is working in the market, and this creates opportunities in other factors that are lagging. This is also what makes factor investing difficult. For investors who are less patient or are looking for a strategy that always keeps pace with the market, factor investing may not be the best strategy for them.

If factors come in and out of favor, then what if we tried to time our factor exposure based on where we are in the economic and market cycle? It may seem logical, but this is very difficult to do. Take the example of value stocks above. If value stocks go through a long period of underperformance relative to growth, and the relative valuations look attractive based on what has happened historically, an investor may decide to up their value exposure. This may be a good decision in the long-term, but over the short run, trying to time the turns in factors accurately and consistently is almost impossible for most investors.

For these reasons, investors should take a long-term view when investing in indices, portfolios or strategies that utilize one or many factors. In addition, finding the factors you believe in the most is the most important factor in an investor’s ability to stick with a factor strategy.

Finding the Top Multi-Factor Stocks

We’ve learned how to define a factor, what the major factors are and the important realities of factor-based investing. Factors can be used in isolation (i.e., finding the top value stocks) or investors can use multiple factors simultaneously to uncover stocks that score highest. Combining multiple factors takes the guesswork out of trying to determine which factor is best to use and can also give investors the confidence that the stock ranks highly on multiple fronts and not just through the lens of one factor.

Investors who are looking for the top multi-factor stocks in today’s market can use the link below to see what stocks are currently exhibiting high overall factor scores. The combined factor score ranks all stocks using a combination of value, momentum, quality and low volatility. The stocks with the highest scores and the greatest consistency across factors will receive the best rankings.

See the Highest Scoring Multi-Factor Stocks in Today’s Market

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