- 1Factor investing identifies specific characteristics that drive stock returns
- 2Six factors have survived decades of academic scrutiny: profitability, momentum, value, low volatility, investment, and short interest
- 3Factor strategies are used by institutions managing trillions of dollars
- 4Academic research shows factors can add 2-5% annual returns over time
#What Is Factor Investing?
Factor investing is an investment strategy that targets specific drivers of return across asset classes. Instead of picking individual stocks based on gut feeling or tips, factor investors systematically identify characteristics—called "factors"—that have historically predicted which stocks will outperform.
Think of factors as the DNA of stock returns. Just as DNA determines physical traits, factors determine a stock's expected performance characteristics.
The concept emerged from a simple question: Why do some stocks consistently outperform others?
Decades of academic research have identified the answer. Certain measurable characteristics—like a company's profitability, price momentum, or valuation—reliably predict future returns across markets, time periods, and geographies.
#The Six Academically-Validated Factors
Not all "factors" are created equal. Of the hundreds proposed by researchers, only a handful have survived rigorous testing. Here are the six with the strongest empirical support:
1. Profitability (Quality)
What it measures: How efficiently a company converts revenue into profit
Why it works: Profitable companies generate cash, reinvest in growth, and survive downturns. Unprofitable companies dilute shareholders and often fail.
Academic source: Ball, Gerakos, Linnainmaa & Nikolaev (2016), Journal of Financial Economics
Historical premium: 3-5% annually
2. Momentum
What it measures: Stocks that have risen over the past 12 months (excluding the most recent month)
Why it works: Behavioral biases cause investors to underreact to good news. Trends persist longer than they "should."
Academic source: Jegadeesh & Titman (1993), Journal of Finance—confirmed by the original authors 30 years later in 2023
Historical premium: 4-8% annually
3. Value
What it measures: Stocks trading at low prices relative to fundamentals (earnings, book value, cash flow)
Why it works: Investors overpay for "exciting" growth stocks and underpay for boring value stocks. Value stocks are also riskier, so investors demand higher returns.
Academic source: Fama & French (1992); Arnott, Harvey, Kalesnik & Linnainmaa (2021) for modern intangible adjustments
Historical premium: 2-4% annually (varies by definition)
4. Low Volatility
What it measures: Stocks with lower price fluctuations
Why it works: Investors overpay for "lottery ticket" stocks with high volatility. Calm, boring stocks are systematically underpriced.
Academic source: Ang, Hodrick, Xing & Zhang (2006), Journal of Finance
Historical premium: 2-3% annually with lower risk
5. Investment (Conservative)
What it measures: Companies that invest conservatively rather than aggressively expanding assets
Why it works: Aggressive investment often destroys value. Companies that grow carefully tend to allocate capital more wisely.
Academic source: Fama & French (2015), Journal of Financial Economics
Historical premium: 2-3% annually
6. Short Interest
What it measures: How much of a stock is being shorted by sophisticated investors
Why it works: Short sellers do extensive research. High short interest often signals problems that haven't yet shown up in financial statements.
Academic source: Rapach, Ringgenberg & Zhou (2016), Journal of Financial Economics
Historical premium: 3-5% annually (for stocks with low short interest)
#Why Do Factors Work?
Factor premiums exist for three main reasons:
1. Risk-Based Explanations
Some factors compensate investors for bearing additional risk. Value stocks, for example, are often distressed companies that might fail in recessions. Investors demand higher expected returns for this risk.
2. Behavioral Explanations
Investors make systematic mistakes. They chase recent winners (creating momentum opportunities), overreact to bad news (creating value opportunities), and prefer exciting, volatile stocks (creating the low-volatility anomaly).
3. Structural Explanations
Some investors face constraints that create opportunities for others. Many institutions can't short stocks or use leverage, so anomalies persist even after being discovered.
#Factor Investing vs. Stock Picking
| Aspect | Stock Picking | Factor Investing |
|---|---|---|
| Basis | Individual analysis, intuition | Statistical characteristics |
| Diversification | Often concentrated | Broadly diversified |
| Track record | Most underperform | 50+ years of evidence |
| Transparency | Varies widely | Fully systematic |
| Scalability | Limited | Highly scalable |
#Who Uses Factor Investing?
Factor strategies are the backbone of institutional investing:
- AQR Capital Management - $100+ billion in factor strategies
- Dimensional Fund Advisors - $600+ billion, founded on factor research
- BlackRock - Offers factor ETFs managing hundreds of billions
- Vanguard - Factor-based "smart beta" funds
- Most pension funds - Use factors for portfolio construction
If it's good enough for the institutions managing the world's retirement savings, it's worth understanding.
#Common Misconceptions
"Factors stopped working"
Some factors have periods of underperformance—value notably struggled 2017-2020. But long-term evidence remains strong. The original momentum researchers confirmed their findings still hold after 30 years (Jegadeesh & Titman, 2023).
"It's just data mining"
Valid concern. Researchers have tested 452 proposed factors—most don't replicate. But the six core factors we use survive the strictest statistical tests (Hou, Xue & Zhang, 2020).
"Everyone knows about factors now"
Factors were discovered decades ago yet still work. Behavioral biases don't disappear because we know about them. You know you shouldn't eat the whole pizza, but...
#How to Apply Factor Investing
Option 1: Factor ETFs
Buy ETFs that target specific factors (value, momentum, quality). Simple but limited customization.
Option 2: Multi-Factor Funds
Funds that combine multiple factors in one portfolio. Better diversification.
Option 3: Quantitative Ranking Systems
Use factor scores to rank individual stocks. Identify which stocks score highest across multiple factors. This is the approach we use—ranking 3,000+ stocks monthly using all six validated factors.
#Getting Started
Factor investing isn't about finding the next Amazon. It's about systematically tilting your portfolio toward characteristics that have predicted returns for 50+ years.
The evidence is overwhelming. The question isn't whether factors work—it's whether you'll use them.
#Further Reading
- Fama, E. F., & French, K. R. (1992). "The Cross-Section of Expected Stock Returns." Journal of Finance
- Jegadeesh, N., & Titman, S. (1993). "Returns to Buying Winners and Selling Losers." Journal of Finance
- Asness, C. S., Moskowitz, T. J., & Pedersen, L. H. (2013). "Value and Momentum Everywhere." Journal of Finance
Last updated: February 1, 2026