What Factors Are
Factors are shared traits, like cheapness or recent strength, that researchers have linked to differences in stock returns. Here is where the idea came from, the main factors and why they may work.
Traits that explain returns
A factor is a measurable characteristic that groups of stocks share. Researchers found that, over long periods, some traits were linked to higher average returns than the market: being cheap, being small, being profitable or having risen recently. Factor investing tilts a portfolio toward those traits on purpose.
The main factors
| Factor | Tilts toward | Common measure |
|---|---|---|
| Market | Owning stocks at all | Stock returns minus cash |
| Value | Cheap stocks | Price to book, price to earnings |
| Size | Smaller companies | Market value |
| Quality or profitability | Profitable, low-debt companies | Return on equity, margins |
| Momentum | Recent winners | Past 6- to 12-month return |
| Low volatility | Calmer stocks | Price swings or beta |
Definitions vary by researcher and fund.
Where the idea came from
In the early 1990s, economists Eugene Fama and Kenneth French showed that market exposure, size and value explained much of the difference between stock portfolios’ returns. Momentum was added later in the decade, and profitability and investment factors in 2015. Hundreds of other factors have been proposed since, and many do not hold up.
Why might factors work?
- Risk: cheap or small stocks may be riskier, so investors demand higher returns.
- Behavior: investors may overreact to bad news and underreact to good news.
- Constraints: some investors cannot use leverage, so they overpay for risky stocks.
- Or luck: some factors found in old data may not persist.
Key takeaways
- Factors are shared traits linked to returns.
- The main ones are value, size, quality, momentum and low volatility.
- Fama and French pioneered factor research.
- Factors may reflect risk, behavior or luck.