Factor investing is the systematic approach to identifying and investing in characteristics that drive returns. Value, momentum, quality, and size are empirically documented factors. Exposure to these factors explains return variations across assets. Factor investing is quantitative investing in its purest form.
The Value Factor
Value stocks (low price-to-book, low price-to-earnings) outperform growth stocks over long periods. This value premium has persisted for 100+ years across geographies. Why? Because value stocks are discounted due to pessimism. As sentiment normalizes, prices recover.
Implementing value requires care. Deep value can be value traps. A stock is cheap for a reason sometimes. Combining value with quality (strong balance sheets, profitability) filters out traps and improves results.
The Momentum Factor
Winner stocks (recent price increases) tend to continue outperforming, while loser stocks continue underperforming, for 3-12 months. This momentum premium is opposite the mean reversion hypothesis. Both exist, but operate on different timescales: momentum is 3-12 months, mean reversion is intraday to days.
Momentum requires careful implementation. Avoid catching falling knives during momentum breaks. Use volatility filters to avoid momentum in low-liquidity stocks. Combine momentum with mean reversion for robustness across regimes.
The Quality Factor
High-quality companies (high profitability, low debt, high cash conversion) outperform over long periods. Investors systematically underprice quality due to extrapolating past disappointments. As quality compounds, valuations re-rate higher.
Quality and value can conflict. Expensive quality stocks vs. cheap low-quality stocks create active choice. Combining factors requires factor correlation analysis. Uncorrelated factors provide diversification benefits.
The Size Factor
Small-cap stocks outperformed large-caps historically, but inconsistently. Size premium appears and disappears by decade. In many recent periods, large-cap outperformance dominated. Size is a weaker factor than value or momentum, but correlations differ over time.
Combining Factors
Multi-factor portfolios diversify across factor exposure. Value provides stability; momentum provides upside capture; quality provides downside protection. Factors often work together, sometimes conflict. Correlation-aware combination improves risk-return profiles.
Factor timing is theoretically possible but practically difficult. Predicting which factors will outperform next period is hard. Systematic diversification across factors with dynamic weighting provides a middle ground: not fully committed to factor timing, but responsive to changing conditions.
Educational content only. Not investment advice.