Factor investing: a gentle introduction

Factors help explain the sources of stock returns, and factor investing is a disciplined approach to capture these differences in order to achieve higher risk-adjusted returns.

Photo by Lukas Blazek / Unsplash

This is the first post in a series introducing factor investing. While the term may be new to you, the concept itself is anything but. It stems from decades of academic research dating back to the 1960s, all driven by a fundamental question: what explains stock returns?
The fact that we’re still discussing this question today might suggest we lack answers, but the reality is that we know a lot.

This series will delve into factor investing at a slightly more advanced level than you might be used to. Yes, there will be formulas, but don’t be discouraged. You don't need the equations to invest in factors, but having a grasp of the theoretical foundations of this field will make you a better investor overall. If you decide to tilt your portfolio towards specific factors, understanding the reason for their existence should make you more likely to stick to the plan in periods of underperformance. In truth, if you are a broad market investor, then you're already a factor investor; market risk is the first one. Before diving into the details, however, it's important to at least get a sense of where we're going, what factor investing is all about, and why it makes sense to consider it for your portfolio.

Choosing a globally diversified, market-cap-weighted portfolio that provides exposure to overall market returns is a perfectly reasonable strategy for the average investor. In fact, by investing in the market as a whole, you become the average; you are the market. For every investor who achieves above-average returns, there must be someone underperforming to balance the equation. In that sense, aiming for the average already puts you in a better position than most. There is nothing wrong with aiming for the average; by all means, it's a solid and easy-to-implement choice. That doesn’t mean it’s impossible to do better, however. There is a rational and methodical way to do so.

To obtain above-market returns, you need to understand where those returns come from in the first place. When we talk about the stock market, it often feels like a single entity, but it's far from being one. The market is composed of thousands of companies around the world, each vastly different from the next. Some are small while others are massive; some are financially sound while others carry heavy debt; some trade at extreme valuations while others appear cheap; some generate stready profits while others struggle to break even. In other words, the market is not a uniform whole but a collection of groups of companies that share certain characteristics. These groupings aren’t about industries in the traditional sense: it’s not that all car manufacturers, or all tech firms, behave the same. Instead, the commonalities we are interested in are more fundamental, and these attributes that characterize them influence the returns they generate and the risks they carry in a systematic way.

Imagine splitting the market into two: in one bin you put the smallest companies, and in the other the largest. Even if you’ve never heard of factor investing, your intuition alone should tell you that these two groups are not alike; they don’t behave in the same way. Smaller firms, for instance, might struggle more during recessions, while larger ones often have the resources to weather the storm. When markets are booming, however, those same smaller firms can grow much faster than their larger counterparts. And when they need to raise money, lending to one group typically feels safer than lending to the other.
This simple exercise shows that the risks posed by these two groups are not the same. If one group is riskier, then as an investor focusing on a slice of the market, you should expect higher returns for taking on that additional risk. Factor investing is simply a systematic way of identifying and capturing these differences.

In this sense, then, each factor is a different dimension of risk and, historically, many factors have provided better risk-adjusted returns than the broader market. In summary, through factor investing, you can:

Increase expected return for a similar level of volatility
Reduce volatility while maintaining a similar level of returns
Improve portfolio diversification

As the first factors were identified and the field itself gained traction and widespread attention, a frenzy of research papers was published claiming to have found new ones. In many cases, the motivation was less about genuine scientific progress and more about riding the wave of a fashionable research topic; estimates suggest that more than 300 of them have been "identified" in the literature.

Subsequent scrutiny, however, has revealed that a significant portion of these "discoveries" is not truly novel. Many are simply rebranded or slightly modified versions of previously known factors. More troublingly, a large fraction have failed to withstand out-of-sample tests or have disappeared entirely once subjected to broader datasets. This lack of robustness hints that numerous reported factors are merely statistical artifacts.

A probable explanation is data mining. Researchers, often under pressure to publish, may unintentionally, or in some cases deliberately, “torture the data” until a significant result emerges. When hundreds of candidate signals are tried, some will inevitably appear significant by chance alone, even in the absence of any true underlying effect. The theoretical justification for many of these "factors" is often weak, often added after the fact to give their existence a moderate level of plausibility.

Regardless of how the situation came to be, for an investor, the critical task is to distinguish genuine factors from mere statistical coincidences. In practice, a factor should meet several stringent criteria before being considered credible:

Persistent: the factor should appear consistently across long periods of time, rather than being confined to a specific sample or historical window.
Pervasive: the factor should hold across different asset classes, regions, and sectors, not just in a narrow corner of the market.
Robust: the factor should remain significant even when its definition is modified slightly or when alternative measurement methods are applied.
Investable: a factor must be accessible in a cost-effective way. If it cannot be implemented after accounting for trading costs, liquidity constraints, and other frictions, it has little practical value.
Sensible: Finally, there should be a sound economic or behavioral rationale underpinning the factor’s existence.

When examined under this lens, only a small fraction of the many proposed factors survive. This series will focus on the handful of core factors that enjoy a stronger academic consensus. Hopefully, this brief introduction to the topic is enough of a tease for you to put up with some equations in the following chapters, if so, you can start here: