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Factor Investing

Difficulty intermediate

Overview

Factor investing targets specific drivers of returns (factors) that have historically delivered excess returns over the market.

The Fama-French Factors

3-Factor Model

R_i - R_f = β_mkt(R_m - R_f) + β_smb×SMB + β_hml×HML + α

SMB = Small Minus Big (size factor)
HML = High Minus Low (value factor)

where: R_i asset return · R_f risk-free rate · R_m market return · β_mkt market beta · β_smb size beta · β_hml value beta · SMB small-minus-big return spread · HML high-minus-low book-to-market spread · α intercept (manager skill). does: decomposes excess return into market, size, and value premia. Industry-standard linear regression for explaining cross-sectional equity returns and isolating residual alpha.

5-Factor Model

R_i - R_f = β_mkt(R_m - R_f) + β_smb×SMB + β_hml×HML
            + β_rmw×RMW + β_cma×CMA + α

RMW = Robust Minus Weak (profitability)
CMA = Conservative Minus Aggressive (investment)

where: β_rmw profitability beta · β_cma investment beta · RMW robust-minus-weak operating profitability spread · CMA conservative-minus-aggressive investment spread · other terms as in the 3-factor model. does: extends Fama-French to capture quality (profitability) and investment behavior. Used to test whether momentum or quality strategies are truly delivering alpha or just loading on known factors.

Common Factors

Factor Definition Economic Rationale
Market Excess market return Risk premium
Size Small cap - Large cap Liquidity premium
Value Cheap - Expensive Distress risk, behavioral
Momentum Winners - Losers Underreaction, behavioral
Quality High profitability Risk premium
Low Vol Low vol - High vol Leverage constraints
Carry High yield - Low yield Risk premium

Factor Performance

Factor Annualized Return Volatility Sharpe Max DD
Market 8-10% 15-20% 0.4-0.6 -50%
Size 1-3% 10-15% 0.1-0.2 -30%
Value 3-5% 10-12% 0.3-0.4 -40%
Momentum 5-8% 15-20% 0.3-0.5 -30%
Quality 2-4% 8-12% 0.2-0.3 -20%
Low Vol 2-4% 8-10% 0.3-0.4 -25%

Practical Guidelines

  1. Factors Cycle — No factor works all the time
  2. Patience Required — Factors need 3-5+ years to play out
  3. Diversify Factors — Combine uncorrelated factors
  4. Costs Matter — High turnover erodes factor returns
  5. Implementation — Use ETFs or systematic rebalancing
  6. Capacity — Some factors degrade with too much capital

Next Steps