Traditional index funds track the market. Factor investing goes further, systematically targeting characteristics associated with higher returns. This is evidence-based investing at its most sophisticated.
What Are Factors?
Factors are characteristics of stocks that explain their returns beyond just market exposure.
Market Factor (Beta): Exposure to the overall market. All stocks have this.
Beyond-Market Factors: Characteristics that have historically provided excess returns:
- Value
- Size
- Momentum
- Quality
- Low Volatility
These premiums have been identified across multiple markets, time periods, and asset classes.
The Major Factors
Value
Definition: Stocks trading at low prices relative to fundamentals (earnings, book value, cash flow)
Academic Evidence: Fama and French (1992) documented the value premium. Value stocks have outperformed growth stocks by ~3-5% annually over long periods.
Rationale:
- Behavioral: Investors overpay for glamour, underpay for boring
- Risk-based: Value companies are riskier, compensation for risk
Metrics:
- Price-to-Book (P/B)
- Price-to-Earnings (P/E)
- Price-to-Cash Flow
- Enterprise Value/EBITDA
Size (Small Cap)
Definition: Smaller companies, measured by market capitalization
Academic Evidence: Small companies have historically outperformed large companies by ~2-3% annually.
Rationale:
- Less analyst coverage means more mispricing opportunities
- Riskier businesses require higher returns
- Less liquid, harder to trade efficiently
Implementation: Small-cap index funds, small-cap value for combined exposure
Momentum
Definition: Stocks that have performed well recently continue to perform well in the short term (3-12 months)
Academic Evidence: Jegadeesh and Titman (1993). One of the strongest factors, ~3-6% annual premium historically.
Rationale:
- Behavioral: Underreaction to news, herding
- Risk: Unknown, debated
Challenge: High turnover, tax-inefficient, expensive to implement
Quality
Definition: Companies with high profitability, low debt, stable earnings
Academic Evidence: Novy-Marx (2013) on profitability. Quality firms outperform junk.
Metrics:
- Return on Equity (ROE)
- Debt-to-Equity
- Earnings stability
- Gross profit margin
Rationale: High-quality companies are underpriced because investors chase growth
Low Volatility
Definition: Stocks with lower volatility than the market
Academic Evidence: Low-vol stocks have historically provided higher risk-adjusted returns—the "low volatility anomaly."
Rationale: Behavioral—investors prefer lottery-like stocks, overpricing high-vol names
Implementation: Minimum volatility or low-beta funds
Factor Implementation
Single-Factor Funds
Target one factor through a rules-based approach:
- iShares Edge MSCI USA Value Factor ETF (VLUE)
- Vanguard Small-Cap Value ETF (VBR)
- iShares MSCI USA Momentum Factor ETF (MTUM)
- iShares MSCI USA Quality Factor ETF (QUAL)
Multi-Factor Funds
Combine factors in one portfolio:
- iShares MSCI USA Multifactor ETF (LRGF)
- Goldman Sachs ActiveBeta U.S. Large Cap Equity (GSLC)
- Vanguard US Multifactor ETF (VFMF)
Dimensional Fund Advisors (DFA)
Pioneer of factor investing. Tilts portfolios toward value, size, and profitability. Available through fee-only advisors.
Avantis (American Century)
Newer entrant with factor-tilted ETFs at lower costs than DFA.
Expected Premiums
Historical factor premiums (approximate, vary by time period):
| Factor | Historical Premium |
|---|---|
| Market (Equity) | 5-7% over cash |
| Size | 2-3% over large cap |
| Value | 3-5% over growth |
| Momentum | 3-6% over market |
| Quality/Profitability | 2-4% over market |
| Low Volatility | Risk-adjusted improvement |
Important: Premiums vary widely by time period. Value has underperformed for the past decade. Past premiums don't guarantee future premiums.
The Case Against Factor Investing
1. Premiums May Not Persist
Once a factor is discovered and published, investors pile in, potentially arbitraging away the premium.
2. Timing Uncertainty
Factors can underperform for extended periods. Value has lagged growth for 10+ years. Can you hold on?
3. Higher Costs and Complexity
Factor funds charge more than broad market index funds. Multi-factor strategies add complexity.
4. Tax Inefficiency
Higher turnover (especially momentum) creates taxable events.
5. Overfitting Risk
With enough data, you can find any "factor." Many published factors don't replicate out of sample.
Factor Investing Done Right
1. Understand the Research
Don't invest in factors you don't understand. Read Fama-French, Carhart, Asness.
2. Long Time Horizon
Factor premiums are not yearly phenomena. Expect 10-20 year holding periods to realize benefits.
3. Diversify Factors
No single factor wins every period. Combining factors reduces volatility of relative returns.
4. Keep It Simple
A total market fund + small-cap value tilt captures most factor benefits with minimal complexity.
5. Tax Location
Hold factor funds in tax-advantaged accounts when possible.
6. Reasonable Expectations
Don't expect factor premiums to deliver quickly or consistently. They're long-term bets.
Practical Portfolio Tilts
Conservative Factor Tilt
- 80% Total Market Index
- 10% US Small Cap Value
- 10% International Small Cap Value
Moderate Factor Tilt
- 60% Total Market Index
- 15% US Small Cap Value
- 15% International Small Cap Value
- 10% Multi-Factor (US or Global)
Aggressive Factor Tilt
- 25% Total Market Index
- 25% US Small Cap Value
- 25% International Small Cap Value
- 15% Momentum (tax-advantaged only)
- 10% Quality
The Bottom Line
Factor investing represents the practical application of academic finance research. Value, size, momentum, and quality have historically provided premiums beyond market returns. However, factors can underperform for extended periods, costs are higher, and past premiums may not persist. For sophisticated investors with long time horizons and tolerance for tracking error, a modest factor tilt can potentially improve returns.