You’re a Factor Investor. You Just May Not Know It Yet

Key Takeaways

• Investment factors are sources of security return. Factors can be thought of as characteristics that help explain investment behavior. Some of the more popular investment factors are value and size. Quality and momentum are factors that have been slightly more dominant over the past 10 years. All the other factors have underperformed.
• For many investors, owning a broad index has been a successful bet over the past decade. However, for years like 2022, when the broad equity market was down, quality was the worst-performing factor, and all the other factors beat the market that year. So times like that, or even more extended periods when the stock market has not done very well, factor bets have paid off.
• Disadvantages to factor-based exchange-traded fund portfolios would mainly include underperformance that is not just in a given calendar year but over an extended stretch of time. However, if you are a big believer in the value premium or the size premium, there can be advantages to this portfolio construction because you have the opportunity to produce superior returns over the long term or low volatility stocks if you want to participate in the market but have a smoother ride.
• For investors heavy in the momentum and quality factors, they could make a factor tilt through passive strategies that track factor indexes. There are also active funds that are giving some factor tilt.
• When rebalancing, investors might want to think about how they might position their portfolio to be ready for a different kind of market regime because markets are dynamic and what has worked well recently might not work well in the future.

Susan Dziubinski: Hi, I’m Susan Dziubinski with Morningstar. Investors can examine the risk and return of their portfolios through many different lenses. Those lenses typically include broad asset classes, such as stocks and bonds. Or perhaps, US investments and international ones. The Morningstar Style Box and sector are popular lenses, too. There’s another lens through which to view a portfolio: investment factors. Here with me today to discuss what investment factors are and what investors can learn about their portfolios from them is Dan Lefkovitz. Dan is a strategist with Morningstar Indexes and co-host of The Long View podcast.

Great to see you today, Dan.

Dan Lefkovitz: Always great to be with you, Susan.

What Are Investment Factors?

Dziubinski: Dan, let’s start out with a definition of what investment factors are.

Lefkovitz: The sources of security return is the technical definition. I like to think of factors as characteristics that help explain investment behavior. Take stocks, we’re going to talk about equities, right?

We’ve got the broad stock market, which is usually proxied through an index, and it goes up or goes down. And then we have the individual stocks within the market, and they each have their unique story, but they’re also these groupings of stocks with similar characteristics or factors, and these factors can help explain differences in risk and return and behavior. Factors really come from the world of academic finance, and there’s a lot of research on them. And they’re not just about explaining divergence within the market. They’re also about finding sources of superior returns or lower risk. So, you hear terms like factor premium or factor anomaly, and that really gets at, there’s some reason that a factor or a characteristic for security might lead to superior returns for some risk-based reason or maybe a behavioral reason.

Most Popular Types of Investment Factors

Dziubinski: All right. So then walk us through some of, let’s say, the most common or more popular investment factors and what they mean.

Lefkovitz: You mentioned the Morningstar Style Box. So, there’s some overlap. Anyone familiar with that three-by-three matrix will know two factors: value and size. Now, the style box is meant to be descriptive of where a stock or where a fund’s portfolio plots in the market by investment style or market capitalization, but there is this notion that value stocks outperform or have outperformed over the long term, that smaller stocks have outperformed over the long term, as compensation for taking more risk, or in the case of value stocks, maybe because they are underestimated.

Now, we on the Morningstar index side have built out a family of factor indexes that are derived from the Morningstar Risk Model. The Morningstar Factor Profile, which is available on Morningstar.com, also uses the risk model definitions. In addition to value and size, we also have quality and momentum, and then we’ve got yield and low volatility. Those are the six factors. There are other factors out there that have been identified in the academic literature. The term factor zoo has been used for all the different factors out there, but those are standard, well-accepted factors, and we find them useful for explaining divergence within the stock market.

Top-Performing Investment Factors

Dziubinski: Got it. You recently wrote a column on Morningstar.com that included this really amazing periodic table of factor performance over the past decades, and I hope readers check it out. We’re providing a link to it beneath this video. Tell me, have there been a few factors that have maybe been a little bit more dominant over the past 10 years?

Lefkovitz: The great thing about that table is it just shows the changeability of factor returns year to year. It looks like a patchwork quilt, but you’ll notice that there are a couple of factors that have outperformed. Well, first what you’ll notice is that the market has been really, really hard to beat. The US equity market has produced phenomenal returns, the broad market for the past 10, even 15 years. There are only two factors that have beaten the market: quality and momentum. Quality, profitable stocks, anyone familiar with the “Magnificent Seven,” that phenomenon, the FANG stocks before that, will not be surprised to hear that very profitable stocks have remained very profitable and have produced phenomenal returns over the past 10 years. Momentum is a chameleon factor. It latches on whatever has done well recently. So, momentum over the past 10 years has ridden that quality wave. Now, when the market direction changes, momentum can get tripped up, but over the past 10 years, it has performed very well.

Worst-Performing Investment Factors

Dziubinski: All right. Let’s look at the flip side then. Are there particular factors that may have consistently not done too well over the past 10 years?

Lefkovitz: Well, not consistently because that factor table shows that year to year, it’s very changeable, but over the past 10 years, all the other factors have underperformed. So, value and size have lagged the broad market. Yield and low volatility have lagged the broad market. And it’s funny, you used to hear a lot more about factor investing five or 10 years ago. Smart beta, ETFs, Morningstar calls it strategic beta, but that packaged these factor premia or factor anomaly. We’re a lot more popular and got a lot more airtime. But because the broad market has done so well, factor investing is just not as popular as it used to be.

Factor Investing for Diversified Portfolios

Dziubinski: Now, investors who have diversified portfolios already have exposure probably to all of these factors to some degree, and you can really see that if you look at the factor profile of a broad-based index fund like Vanguard Total Stock Market ETF VTI

, right? You look at that, and you can see how the factors are at play in that fund. Given that most investors have these diversified portfolios, what are some takeaways from factors for this particular type of investor?

Lefkovitz: For many investors, just owning a broad index fund is a perfectly fine way to go and has certainly been the successful bet over the past 10, 15 years. But I will say that there are years, like 2022 was a big down year for the US stock market, inflation, interest rates were going very drastically, and the broad equity market was down, quality was the worst-performing factor, and all the other factors beat the market that year. So times like that, or even more extended periods where the stock market has not done very well, factor bets have paid off. I’ll also say that the composition of the market has changed a lot. Because of quality’s long run, because the market has gotten very concentrated, some of these trillion-dollar-plus quality stocks and an investor holding a broad market portfolio probably have more exposure to the quality factor than they used to, and less exposure to factors like value and to size. Just by holding a market portfolio, your factor exposures can change.

Benefits and Disadvantages of Factor-Based ETF Portfolios

Dziubinski: Got it. Now, some investors might be working with advisors who use factor-based ETFs to construct portfolios around the factor concept. Now, I know you’re not a portfolio strategist, but what might be some of the advantages or disadvantages to taking that approach to invest in a portfolio?

Lefkovitz: Disadvantages, I think we’ve discussed. Underperformance, not just in a given calendar year but over an extended stretch of time, like 10 or 15 years, can come with the territory of factor investing. Factor investing requires a lot of patience, a lot of intestinal fortitude to stick it out. Advantages, if you are a big believer in the value premium or in the size premium, you have the opportunity to produce superior returns over the long term or low-volatility stocks if you want to participate in the market but have a smoother ride; that might be a vehicle there. There is a concept of multifactor investing where you diversify buy factor in a way that gives you an exposure that’s different to market exposure, and that would lower the risk of relative underperformance, but individual factor investing is really hard.

How Can Investors Tilt Their Portfolios Toward Factors?

Dziubinski: Then you also have some investors that maybe have that diversified portfolio, but maybe for a tactical reason might want to lean into a particular factor over time, or maybe they’ll find, as you said, if you have a total market index fund these days, you’re probably a little heavy in the momentum factor and the quality factor, for instance. So, for these investors, how could they make a factor tilt if they wanted to?

Lefkovitz: There are lots of ETFs and index funds, passive strategies that track factor indexes like the kind that we’ve created. There are also active funds that are giving some factor tilt, lots of great-value funds out there, or small-cap funds out there that are actively managed. If you’re a purist on the factor side, you might prefer a passive vehicle because it’s systematic and it’s disciplined and it’s going to stick to the factor exposure over the long term. It should be low cost as well. The advantage on the active side is that you can add some alpha and maybe some factor diversification. Lots of great resources on Morningstar.com data and research that would help you if you wanted to be a factor investor.

How to Use Factors When Rebalancing

Dziubinski: Got it. Then, we’re coming to the time of year where investors are thinking about rebalancing, taking some chips off the table here, maybe reallocating them over here based on what’s been doing well and not been doing well in the market. How can investors use the factor research that you’ve been doing or use factors as a part of that process? How could they be thinking about it?

Lefkovitz: I don’t know what the future holds, but I will say that it’s very possible. Some would say likely that the next 10 years, the next 15 years, won’t be as successful for the broad US equity market as the last have been, and maybe factor investing will be more successful, and some of these factor bets will pay off in ways that they haven’t. I think about the first decade of the century, 2000 through 2009, where the broad market did not do well. It was down over that 10-year period, but value and size were really successful bets over that time frame. You could foresee conditions where factor bets are more successful than they have been recently, and factor investing pays off in ways that it hasn’t. So some investors might want to be ready for such a scenario or think about how they might position their portfolio to be ready for a different kind of market regime because markets are dynamic, and they’re constantly changing, and what has worked well recently might not work well in the future.

Dziubinski: Well, thank you so much for your time, Dan. This was very interesting research about factors. We appreciate it.

Lefkovitz: Thanks, Susan.

Dziubinski: I’m Susan Dziubinski with Morningstar. Thanks for tuning in.

Watch Is Your Portfolio Built to Withstand a Market Rotation? for more from Dan Lefkovitz.