# Understanding Factor Investing: A Strategy for Market Savvy Investors

![Factor Investing: An investment strategy that involves choosing securities based on attributes associated with higher returns.](https://www.investopedia.com/thmb/X6alPxeg06sMIEPAFor8V0TOmNU=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/factor-investing.asp-final-6573b56fdef24f6093ae487966968531.png)

*Factor investing is designed to enhance diversification, manage risk and generate returns that are higher than the market average. — Mira Norian / Investopedia*

## What Is Factor Investing?

Factor investing is an [investment strategy](https://www.investopedia.com/terms/i/investmentstrategy.asp) that involves choosing securities based on attributes that are associated with higher returns. This type of investing aims to reduce risk that may otherwise be hidden in a portfolio of securities with similar exposure. Proponents of factor investing argue that this strategy allows investors to make better decisions.  

### Key Takeaways

*   Factor investing utilizes multiple factors, including macroeconomic as well as fundamental and statistical factors, to analyze and explain asset prices and build an investment strategy.
*   Factors that have been identified by investors include: growth vs. value; market capitalization; credit rating; and stock price volatility, among several others.
*   Smart beta is a common application of a factor investing strategy.

## Types of Factors

The two main types of factors are [macroeconomic factors](https://www.investopedia.com/terms/m/macroeconomic-factor.asp) and style factors. Macroeconomic factors capture broad risks across asset classes. Style factors aim to explain returns and risks within asset classes.

Some common macroeconomic factors include the rate of inflation, GDP growth, and the unemployment rate. Style factors encompass growth versus value stocks; market capitalization; and industry sector.

### Note

Other considerations include microeconomic factors, such as a company's credit, its share liquidity, and stock price volatility, and residual risk, which is not captured by the factor model.

## Understanding Factor Investing

Factor investing is designed to enhance diversification, generate above-market returns, and manage risk. 

Portfolio [diversification](https://www.investopedia.com/terms/d/diversification.asp) has long been a popular safety tactic, but the gains of diversification are lost if the chosen securities move in lockstep with the broader market. For example, an investor may choose a mixture of stocks and bonds that all decline in value when certain market conditions arise. The good news is factor investing can offset potential risks by targeting broad, persistent, and long-recognized drivers of returns.

Compared to traditional [portfolio](https://www.investopedia.com/terms/p/portfolio.asp) allocations like 60% stocks and 40% bonds, factor investing can seem overwhelming and tricky to implement. To simplify their approach, beginners to factor investing can focus on elements such as style (growth vs. value), size ([large cap](https://www.investopedia.com/terms/l/large-cap.asp) vs. [small cap](https://www.investopedia.com/investing/introduction-to-small-cap-stocks/)), and risk (beta). These attributes are readily available for most securities and are listed on popular stock research websites.

#### Smart Beta Pt. 3: Smart Beta in Portfolios

## Foundations of Factor Investing

### Value

[Value](https://www.investopedia.com/terms/v/valuestock.asp) aims to capture excess returns from stocks that have low prices relative to their fundamental value. This is commonly tracked by price to book, price to earnings, dividends, and free cash flow.

### Size

Historically, portfolios consisting of small-cap stocks exhibit greater returns than portfolios with just large-cap stocks. Investors can capture size by looking at the market capitalization of a stock.

### Momentum

Stocks that have outperformed in the past tend to exhibit strong returns going forward. A [momentum strategy](https://www.investopedia.com/terms/m/momentum.asp) is grounded in relative returns from three months to a one-year time frame.

### Quality

Quality is defined by low debt, stable earnings, and consistent asset growth. Investors can identify quality stocks by using common financial metrics like a return to equity, debt to equity, and earnings variability.

### Volatility

Empirical research suggests that stocks with low [volatility](https://www.investopedia.com/terms/v/volatility.asp) earn greater risk-adjusted returns than highly volatile assets. Measuring standard deviation from a one- to three-year time frame is a common method of capturing beta.

## Example: The Fama-French 3-Factor Model

One widely used [multi-factor model](https://www.investopedia.com/terms/m/multifactor-model.asp) is the Fama and French three-factor model, which expands on the [capital asset pricing model (CAPM)](https://www.investopedia.com/terms/c/capm.asp). Built by economists Eugene Fama and Kenneth French, the [Fama and French model](https://www.investopedia.com/terms/f/famaandfrenchthreefactormodel.asp) utilizes three factors:

*   The size of firms
*   Book-to-market values
*   [Excess return](https://www.investopedia.com/terms/e/excessreturn.asp) on the market

In the model's terminology, the three factors used are [SMB](https://www.investopedia.com/terms/s/small_minus_big.asp) (small minus big), [HML](https://www.investopedia.com/terms/h/high_minus_low.asp) (high minus low), and the portfolio's return less the risk-free rate of return. SMB accounts for publicly traded companies with small market caps that generate higher returns, while HML accounts for value stocks with high book-to-market ratios that generate higher returns in comparison to the market.

> **Tip**
>
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## The Bottom Line

Factor investing aims to generate above-market returns by enhancing diversification and managing risk. Beginners to factor investing can simplify their strategy by focusing on factors like growth vs. value, market capitalization, and risk (beta).  

> **Article Sources**
>
> 1.  MSCI. "[Factor Focus: Value](https://www.msci.com/documents/1296102/8473352/Value-brochure.pdf)." Page 2.
>     
> 2.  MSCI. "[Factor Focus: Size](https://www.msci.com/documents/1296102/8473352/Size-brochure.pdf)." Page 2.
>     
> 3.  MSCI. "[Factor Focus: Momentum](https://www.msci.com/documents/1296102/8473352/Momentum-brochure.pdf)." Page 2.
>     
> 4.  MSCI. "[Factor Focus: Quality](https://www.msci.com/documents/1296102/8473352/Quality-brochure.pdf)." Page 2.
>     
> 5.  S&P Dow Jones Indices. "[Low Volatility: A Practitioner’s Guide](https://www.spglobal.com/spdji/en/documents/education/education-low-volatility-a-practitioners-guide.pdf)." Pages 1-2.
>     
> 6.  Fama, Eugene F. and French, Kenneth R. "[Multifactor Explanations of Asset Pricing Anomalies](https://onlinelibrary.wiley.com/doi/10.1111/j.1540-6261.1996.tb05202.x)." _The Journal of Finance_, vol. 51, no. 1, March 1996, pp. 55-84.