Factor investing, also known as smart beta investing, is a form of investing based on factors that are proven to drive stock returns. Research has shown that stock returns are driven mostly by market performance and individual company characteristics but that these five attributes also have contributed notably to returns. Thus, if you screen stocks and only invest in the ones that pass the factor tests, you may beat the market.
The factors are:1
Value (undervalued beats overvalued)
Size (small beats big)
Volatility (low volatility beats high)
Momentum (stocks already going up will keep doing so)
Quality (high returns on capital are better than low)
Other factors that aren’t so consistent or don’t have as much of a factor in driving returns are also sometimes included, dividend yield and trading volume being the most common among those.
Factor investing originated with the Capital Asset Pricing Model (CAPM), which was developed in the early 1960s. The CAPM implied that the main factor for all stocks was the market. The Fama-French model was next, showing that size and value also drive returns.2 Over time, researchers discovered the other factors listed above and showed how they can generate excess returns.
