What Factor Investing Gets Right
Tommi Johnsen, PhD | Advisory Board Trent Ambler, MSF | Portfolio Manager
1. It Identifies the Real Drivers of Returns
Factor investing is built on the premise that certain characteristics, known as factors, consistently drive returns and, more so, drive excess returns. By identifying these factors, investors move beyond vague notions of luck or gut instinct and instead focus on empirically tested drivers of performance. Whether it’s value, momentum, size, or quality, these factors have shown enduring influence across time periods, sectors, and geographies, offering a systematic lens for evaluating market inefficiencies and underlying risk premiums.
2. It’s Rooted in Economic Arguments and Behavioral Logic
Returns from exposure to legitimate factors are not just a statistical quirk and instead are based on sound economic rationale - performance is reflective of persistent behavioral tendencies and biases among investors. Take the value premium as an example. The value risk premium likely stems from investor overreaction to bad news, temporarily depressing prices. Momentum, on the other hand, might be explained by underreaction to good news, followed by herd behavior. By sticking to a rules-based methodology, factor strategies bypass emotional decision-making, allowing investors to capitalize on inefficiencies with discipline and consistency.
3. It Aligns with a Range of Investment Objectives
Factor investing isn’t one-size-fits-all. Different factors naturally suit different investor goals:
Value: Appropriate for long-term appreciation and contrarian strategies.
Size: Appeals to growth-focused investors with a higher risk tolerance. Strategies typically feature aggressive growth, early-stage opportunities, risk-tolerant strategies.
Momentum: Very popular because it works for short and mid-terms tactical positioning in stocks. Labels include trend-following and relative strength investing.
Quality: Favored by investors seeking lower but steady growth with lower risk. Find quality stocks labelled as defensive growth and wealth preservation.
Low Volatility: Attracts risk-averse investors and retirees aiming to preserve capital. Capital preservation, low-risk income, and retirement income strategies.
4. It Exploits Behavioral Biases Systematically
What sets factor investing apart is its ability to systematically exploit behavioral biases. From overreaction to underreaction, from trend-chasing to risk aversion, human behavioral tendencies do shape markets in predictable ways. Factor strategies are designed to harness the systematic nature of human biases with disciplined execution.
5. It’s Backed by Robust Empirical Evidence
Decades and decades of peer-reviewed academic and practitioner research have validated the long-term veracity of factor strategies. These studies have tested commonly accepted factors like value, size, quality, sentiment, and momentum globally, and across asset classes. The results have been astounding! Persistent return premiums have been documented that are free of data anomalies, free of backtesting biases, backed by theory and reflect fundamental economic behavior.
6. It’s Grounded in Long-Term Data and Technology
Speaking of data, factor investing doesn’t rely on guesswork or intuition. Its foundations lie in large datasets, backtested models, and academic validation. The persistence of factor premiums over time and across countries tell us that they are not statistical flukes.
Advances in computing, data availability, and machine learning have made factor investing smarter and more responsive. Modern commercial datasets now contain well over 100 million different datapoints. Today’s models scan this real-time information, from earnings releases to social media sentiment, to refine factor exposure dynamically. AI tools can now assist in evaluating new signals, building portfolios, and managing risk with precision.
7. It Enhances Risk Management, Diversification and is Cost-effective
Traditional diversification spreads assets across regions, asset classes or sectors. Factor diversification digs deeper. Since factors like value, momentum, and low volatility often behave differently depending on market conditions, a multi-factor portfolio can smooth out returns and offer better downside protection. It is difficult to understate the impact of factor diversification. Factor investing makes hidden portfolio risks visible. Knowing your exposure to market-wide risks like sensitivity to interest rates or economic cycle, produces better risk alignment and control.
8. Its results are systematic and not driven by human judgement.
Countless studies have demonstrated that human judgment is inconsistent and ill-suited for environments with huge amounts of complex information[1],[2]. In these “low-validity” environments studies have reliably shown that formula driven approaches far outperform those rooted in human judgment.
People have good days, and they have bad days. We get tired or stressed or overconfident easily. Our emotions and physical capacity, in the moment, greatly influence our ability to process vast amounts of complex information. Humans make decisions based on heuristics, based on emotion, or even vanity. Our instincts and insights can be powerful and useful especially when checked against formula driven approaches that are simply not susceptible to the foibles of the human brain. Formula driven approaches beat those based purely in human judgement and a formula driven approach that “gut-checks” human insight can be even better.
9. It’s not about chasing what’s trendy. It’s about sticking with what’s proven.
Despite its strengths, factor investing isn’t foolproof. Factors can underperform for extended periods and attempts to time them often backfire. Crowding and herding, when too many investors pile into the same factor can also erode returns.
Still, for those who stay the course, factor investing offers a data-driven, transparent, and theoretically sound framework that stands in contrast to the intuition-based world of traditional active management.
[1] Kahneman, Daniel. Thinking, Fast and Slow. Farrar, Straus and Giroux, 2011. Chapter 21, pp. 223-233.
[2] Stephens-Davidowitz, Seth. Don’t Trust Your Gut: Using Data to Get What You Really Want in Life. Dey Street Books, 2022.