Comunicazione di marketingEducational content. No personalized investment advice before the OCF registration is published.
Comunicazione di marketingEducational content. No personalized investment advice before the OCF registration is published.

Factor Investing: Concepts, Evidence, and a Practical Guide for Investors

✍️ Editorial Team•••10 min read

Factor Investing: Concepts, Evidence, and a Practical Guide for Investors

Introduction

Factor investing is an investment approach that focuses on systematic characteristics—the so-called factors—capable of generating long-term excess returns over the market portfolio. Since the formulation of the Capital Asset Pricing Model (CAPM) in the 1960s, researchers have observed valuation anomalies that CAPM alone could not explain: stocks with low multiples, reduced volatility, or favorable recent price trends delivered returns above those predicted by the model. These anomalies were codified as risk factors and, over recent decades, their combination has become increasingly central for both institutional and retail portfolios.

Robeco’s guide clarifies that investing in factors means focusing on market segments with structural properties that historically delivered superior risk-adjusted returns versus the index. Initially confined to academic portfolios, factor investing spread among professionals after a 2009 study on the Norwegian sovereign wealth fund (NBIM) showed that over 70% of active returns were explained by implicit factor exposures. Many investors have since exploited factors deliberately as a third way between passive and active management: rules-based, transparent, low-cost strategies that can still generate alpha.

The approach does not aim to find a single “winning” stock, but to capture these risk premiums in a transparent, systematic way. To reduce the phases of underperformance of individual factors it is advisable to combine several factors in multi‑factor portfolios.

Key rewarded factors

The literature has identified many factors, but only a few meet strict criteria of persistence, pervasiveness (across markets), robustness (to construction methods), investability, and intuitive explanation. Four are widely regarded as “proven” in equities:

  • Value – Stocks with low valuations (e.g., low price-to-book or price-to-earnings) tend to outperform high-valuation stocks. Documented since the 1970s across many markets, “cheap” stocks have delivered higher returns for a given level of risk.
  • Momentum – Stocks with strong recent performance tend, on average, to continue doing well over subsequent months. Formalized in the 1990s, momentum is among the most persistent factor premia.
  • Low Volatility – Stocks with lower volatility or market beta deliver returns higher than their risk would suggest, a CAPM violation confirmed in developed and emerging markets; drawdowns are typically smaller.
  • Quality – Firms with solid fundamentals (persistent earnings, low leverage, strong balance sheets) tend to outperform lower-quality peers; modern definitions also include earnings sustainability and governance.

Other commonly cited factors include size (small-caps vs large-caps), carry/value, and sentiment. Recently, research proposed factors tied to intangibles, such as intellectual capital and reputation: Sparkline Capital, for instance, suggests an “intangible value” factor that invests in firms with strong intellectual capital and brands, delivering returns with low correlation to traditional factors. This reflects the growing importance of intangible assets (brands, IP, human capital) in the modern economy.

Fundamentals and formulas

From CAPM to the Fama–French models

The Capital Asset Pricing Model (CAPM) states that the expected return of an asset depends on the risk‑free rate and on its sensitivity to the market (beta):

E[R] = R_f + β\*(E[R_M] – R_f)

The model can be viewed as a long position on the market and a short position on the risk‑free asset: a stock with β=1.3 is equivalent to holding 130 % of the market and financing 30 % with a short position in the risk‑free asset.

To explain differences in returns not captured by the CAPM, Fama and French introduced the size (SMB) and value (HML) factors. The three‑factor model expresses the excess return of a portfolio as the sum of exposures to the market, the size factor and the value factor.

Empirical evidence

To quantify factor premia, many studies analyze long/short portfolios that buy high-scoring stocks and sell low-scoring ones. Alpha Architect shows that investing in cheap stocks after the dot-com bust (2000–2014) produced about a 4.67% annual premium versus the market. Over the same period, value, momentum, low volatility, quality, and size all outperformed the market. Yet premia are not constant: extended underperformance can test investors’ discipline, who must keep exposure through adverse cycles.

A 2024 Russell Investments report confirms factor performance varies quarter to quarter: in Q3-2024, Low Volatility outperformed the global index by +0.8% to +2.3%, while Momentum and Growth underperformed (–0.7% to –1.8%) and Value delivered mixed results. This highlights the importance of combining multiple factors to mitigate cyclicality.

From theory to practice: building factor portfolios

Robeco distinguishes two main implementation paths:

  • “Pure” single-factor portfolios: maximize exposure to a specific premium (e.g., a value or momentum index). They are simple and transparent but can endure long droughts when the factor faces a negative cycle.
  • Integrated multi-factor portfolios: combine factors within one basket. Integration can be (a) integrated, scoring each stock on multiple factors simultaneously and selecting only if it ranks well across them, or (b) mixed/sleeved, building separate sleeves and aggregating later. Research (AQR/Alpha Architect) finds integrated designs under tracking-error constraints can generate higher alpha than siloed approaches; other work notes sleeves can be competitive when the number of holdings is limited. The choice depends on objectives, turnover costs, and tracking-error capacity.

Factors beyond equities

While most associate factor investing with equities, premia exist in other asset classes: bonds (credit spread, term premium), FX (carry), and commodities (backwardation vs contango). For instance, FX carry buys high-rate currencies and sells low-rate ones; in corporate bonds, value (spreads) and momentum also appear. Cross-asset diversification raises the odds that at least one factor sleeve is in a favorable cycle.

Costs and risks

Factor strategies are not free of costs or risks. Smart-beta ETFs or funds can charge higher fees versus broad beta and may incur higher turnover, with trading costs and tax implications. Product selection is crucial (fees, transparent methodology), and premia can fade if a factor becomes overcrowded or data are not maintained. No strategy is drawdown-proof: value lagged for much of the 2010s; momentum can suffer in sideways markets or sharp reversals.

Human capital as a risk factor

Andrew Ang’s work emphasizes a neglected dimension: human capital also exhibits factor exposures. Labor income represents a large share of overall wealth and can be viewed as a non-tradable asset with bond-like or stock-like traits. If your income is bond-like (stable, low cyclicality), you can assume more financial risk and keep a higher equity weight even near retirement; if it is stock-like (entrepreneur or cyclical sector), it is prudent to hold more bonds or defensive assets to offset human-capital risk.

Recent research quantifies these links. Blanchett and Straehl (2017) estimate average human capital to be ~30% stock-like, with wide sector differences: public-sector workers have near-zero market beta, while mining shows ~0.53. These gaps affect optimal equity weights: public employees may hold up to 76% in stocks, whereas mining workers should cap at ~40%. In Sweden, a 20% increase in wage volatility reduces equity allocation by roughly 20%. Human capital also relates to size and value factors by industry, so cyclical workers should tilt to defensive factors (low vol, quality) and avoid buying their own sector’s risk.

Irrational Capital, with J.P. Morgan, developed the Human Capital Factor® index (culture, morale, engagement). Reports show HCI beat the benchmark every sample year (including 2024), with superior risk/return, lower volatility, and smaller drawdowns—evidence that incorporating human-capital quality can generate durable alpha and underscores the role of intangibles.

Human asset evaluation and personal human capital

Assess whether your job is stock-like or bond-like and how it evolves over your life cycle; this is key to designing a balanced portfolio and choosing factor tilts. A young saver with stable income can lean more into value and momentum; an entrepreneur with volatile income should prefer low volatility, quality, or multi-factor designs with lower market risk.

Investor takeaways

  • Diversify across factors and asset classes. Blend value, momentum, low volatility, quality, and size; extend factors to bonds, FX, and commodities.
  • Evaluate human capital. Gauge income stability and correlation with market factors; if your job is cyclical, reduce exposure to the same sector and increase defensive factor tilts.
  • Pick efficient products. Check methodology, universe, rebalance frequency, and fees. Consider currency-hedged share classes where appropriate.
  • Stay disciplined. Factor premia are cyclical; long horizons and consistency are essential.
  • Consider integrated designs. Integrated multi-factor can improve risk/return, but balance complexity and concentration with your resources and goals.

Conclusions

Factor investing advances beyond the simple active/passive dichotomy. By harnessing documented premia—value, momentum, low volatility, quality, size, and intangibles—investors can enhance risk-adjusted returns and build more robust portfolios. Yet factors are cyclical and demand method and discipline. Incorporating human capital into asset-allocation decisions helps avoid concentrated risks and tailor factor exposure to personal conditions.

References