Factor Investing Explained Simply

A factor is a measurable characteristic of securities that has historically been associated with differences in returns. Factor investing means deliberately overweighting securities that share one or more of these characteristics.

This article explains what factors are, which ones have the strongest academic support, how factor investing is implemented in Australia, and what trade-offs are involved. It does not argue for or against factor tilts.

What a factor is#

In academic finance, a "factor" refers to a characteristic of a group of securities that helps explain why some investments have delivered different returns than others over long periods.

The simplest example is the market itself. Stocks, as a broad category, have historically delivered higher returns than cash or bonds. The "market factor" is the extra return investors have earned for accepting the risk of owning equities rather than holding risk-free assets.

Beyond the market factor, researchers have identified several other characteristics associated with return differences. These are not guaranteed patterns. They are statistical tendencies observed across many decades and many markets, and they remain the subject of ongoing academic debate. The word "factor" simply means: a trait that groups of securities share, and that trait has historically coincided with different return outcomes.

The main factors with academic evidence#

Five factors have attracted the most research attention and institutional adoption. Each has a substantial body of evidence behind it, though none is without periods of underperformance.

Value#

The value factor refers to the tendency of stocks that appear cheap relative to their fundamentals (such as earnings, book value, or cash flow) to outperform stocks that appear expensive by those same measures.

This observation was formalised by Eugene Fama and Kenneth French in their landmark 1992 paper, which demonstrated that stocks with high book-to-market ratios delivered higher average returns than stocks with low book-to-market ratios.^¹ The value premium has been documented across many countries and time periods, though it has been notably weak in some recent stretches, particularly in the decade following the 2008 financial crisis.

Whether the value premium exists because value stocks are genuinely riskier, or because investors systematically misprice them, remains debated.

Size#

The size factor, sometimes called the "small-cap premium," refers to the historical tendency of smaller companies to deliver higher returns than larger companies over long periods. Fama and French included size alongside value in their three-factor model.^¹

The trade-off is straightforward: smaller companies tend to be more volatile, less liquid, and more vulnerable to economic downturns. The higher historical returns may be compensation for these additional risks. In Australia, small-cap stocks listed on the ASX have exhibited higher volatility alongside periods of both meaningful outperformance and underperformance relative to large-cap peers.

Quality#

The quality factor captures the tendency of companies with strong profitability, low debt, and stable earnings to outperform companies with weaker financial characteristics.

Robert Novy-Marx's 2013 research demonstrated that gross profitability was roughly as powerful as book-to-market ratio (value) in predicting stock returns.^² Fama and French later added profitability and investment factors to their original model, expanding it from three factors to five.^³

Quality is sometimes considered puzzling because it seems to offer higher returns without proportionally higher risk. Some researchers argue that the quality premium persists because investors are drawn to exciting, high-growth stories and systematically neglect steady, profitable businesses.

There is something quietly instructive about that: the companies doing unremarkable things well, year after year, sometimes outperform the ones making headlines.

Momentum#

The momentum factor refers to the observation that securities which have recently performed well tend to continue performing well in the short term, and those that have performed poorly tend to continue underperforming. Jegadeesh and Titman's 1993 research provided early formal evidence of this pattern, showing that buying recent winners and selling recent losers generated significant returns over holding periods of three to twelve months.^⁴

Momentum is one of the most robust empirical findings in finance, documented across asset classes and geographies. It is also difficult to explain through traditional risk-based frameworks, which is why behavioural explanations (investor underreaction to new information, followed by delayed overreaction) are commonly cited.

The catch is that momentum can reverse sharply. "Momentum crashes," where recent winners suddenly collapse and recent losers rebound, have occurred historically and can be severe.

Low volatility#

The low volatility factor (sometimes called "minimum variance") captures the counterintuitive finding that lower-risk stocks have sometimes matched or beaten higher-risk stocks over long periods. This contradicts the textbook assumption that higher risk always comes with higher expected return.

Baker, Bradley, and Wurgler (2011) provided evidence that low-volatility stocks have historically delivered comparable or superior risk-adjusted returns compared to high-volatility stocks.^⁵ One explanation is that institutional investors, constrained from using leverage, buy high-volatility stocks to chase higher returns, bidding up their prices and reducing future returns. The low volatility factor is sometimes viewed as a defensive strategy, potentially offering smoother outcomes during turbulent markets, though with the trade-off of lagging during strong bull markets.

A summary of the main factors#

Where factor investing sits: between passive and active#

Pure passive investing means buying a market-cap weighted index fund and accepting the market's return, minus costs. Traditional active investing means a fund manager uses judgement and discretion to select investments they believe will outperform.

Factor investing sits in between. It is systematic (following rules rather than judgement), but it deviates from the market-cap weighted index by deliberately overweighting securities with specific characteristics. This is why it is sometimes called "smart beta" or "systematic investing." Like passive investing, it is rules-based and transparent. Like active investing, it deviates from the broad market and can underperform for extended periods.

A plain market-cap weighted index fund already contains every factor in market-cap proportion. Buying a broad ASX 200 index fund means owning value stocks, growth stocks, small companies, quality companies, and momentum winners, all weighted by market capitalisation. Factor investing is the deliberate decision to overweight some of these characteristics relative to their natural market-cap weight.

How factor tilts are implemented in Australia#

In Australia, factor investing is primarily accessed through exchange-traded funds (ETFs) listed on the ASX and through managed funds that follow systematic strategies.

Several providers offer single-factor and multifactor ETFs on the ASX. These funds track indices constructed using factor-based rules rather than pure market-cap weighting. For example, a value ETF might select stocks based on price-to-earnings ratios, while a quality ETF might screen for return on equity and debt levels. Multifactor funds combine two or more factors into a single product, attempting to capture multiple premiums and provide diversification across factors (since different factors tend to outperform at different times).

The range of factor products available in Australia has expanded in recent years, though it remains smaller than the range available in the United States. Several ETF providers offer factor-based products on the ASX.^⁶

Costs for factor ETFs generally sit between plain market-cap index ETFs and actively managed funds. A broad Australian market index ETF might charge 0.04% to 0.10% per year. A factor ETF might charge 0.20% to 0.50%. An actively managed fund might charge 0.80% to 1.50% or more. As with all investment costs, the difference compounds over time.

The trade-offs of factor investing#

Factor investing involves genuine trade-offs that are worth understanding clearly.

Higher fees than plain index funds#

Factor ETFs charge more than the simplest market-cap index funds. The difference may appear small in any single year, but it compounds. Whether the factor premium (if it materialises) exceeds the additional cost is an empirical question, not a guarantee.

Factors can underperform for long periods#

Any individual factor can underperform the broad market for years, sometimes a decade or more. The value factor, for instance, significantly underperformed growth stocks during much of the 2010s. There is no assurance that past patterns will resume.

Most people find it easier to believe in a strategy when it is working. The real test comes during the years when it is not.

Tracking error relative to the broad market#

A factor-tilted portfolio will not behave like the broad market index. Its returns will deviate, sometimes positively, sometimes negatively. This "tracking error" can be psychologically difficult. Watching a factor-tilted portfolio lag a simple index fund quarter after quarter can prompt abandonment of the strategy at the worst time.

Added complexity#

Factor investing adds decisions: which factors, how many, which products, how to combine them, when to rebalance factor exposures. A single broad market index fund is a complete equity portfolio. Factor tilts are an optional refinement.

The academic foundation#

The academic case for factor investing rests primarily on the work of Fama and French, whose three-factor model (1992) expanded the Capital Asset Pricing Model (CAPM) to include size and value alongside the market factor.^¹ Their model was later expanded to five factors, adding profitability and investment.^³ Mark Carhart's 1997 work added momentum as a fourth factor to the original three-factor model, creating the widely used Carhart four-factor model.

These models do not claim that factors will always deliver excess returns. They describe historical patterns and offer frameworks for understanding return differences. Whether those patterns persist in the future, after the costs of implementation, remains an open question.

The evidence comes with an important caveat: once a factor is widely known and widely invested in, the premium associated with it may shrink. If everyone tilts toward value stocks, the prices of value stocks rise, and the future value premium decreases. This is sometimes called "factor crowding."

Whether beginners need to think about this#

Factor investing is a legitimate area of portfolio construction with serious academic backing. It is also entirely optional.

A plain market-cap weighted index fund already provides exposure to all factors in their natural proportions. An investor holding a broad index fund is not missing out on factors. They are holding them in the weight that the market assigns. Factor tilts are a deliberate decision to overweight certain characteristics, adding complexity, cost, and tracking error.

For someone early in their investing journey, the highest-impact decisions are typically more fundamental: saving consistently, keeping fees low, diversifying broadly, and maintaining discipline during downturns. Factor tilts can be explored later, once the foundation is solid.

There is no urgency. The factors, if they persist, will still be there when you are ready to learn more about them.

Summary#

A factor is a measurable characteristic of securities that has historically been associated with differences in returns, and the main factors supported by academic research are value, size, quality, momentum, and low volatility. Factor investing sits between pure passive indexing and traditional active management, using systematic, rules-based strategies to deliberately overweight specific security characteristics. In Australia, factor tilts are primarily implemented through factor ETFs listed on the ASX, with costs that sit between plain index funds and actively managed funds. A broad market-cap weighted index fund already contains all factors in their natural proportion, making factor tilts an optional refinement rather than a necessity for building a sound portfolio.

Sources#

1. Fama, E. F., & French, K. R. (1992). The cross-section of expected stock returns. The Journal of Finance, 47(2), 427-465. https://doi.org/10.1111/j.1540-6261.1992.tb04398.x

1. Novy-Marx, R. (2013). The other side of value: The gross profitability premium. Journal of Financial Economics, 108(1), 1-28. https://doi.org/10.1016/j.jfineco.2013.01.003

1. Fama, E. F., & French, K. R. (2015). A five-factor asset pricing model. Journal of Financial Economics, 116(1), 1-22. https://doi.org/10.1016/j.jfineco.2014.10.010

1. Jegadeesh, N., & Titman, S. (1993). Returns to buying winners and selling losers: Implications for stock market efficiency. The Journal of Finance, 48(1), 65-91. https://doi.org/10.1111/j.1540-6261.1993.tb04702.x

1. Baker, M., Bradley, B., & Wurgler, J. (2011). Benchmarks as limits to arbitrage: Understanding the low-volatility anomaly. Financial Analysts Journal, 67(1), 40-54. https://doi.org/10.2469/faj.v67.n1.4

1. ASX. (2025). ASX investment products: Exchange traded funds. Australian Securities Exchange. https://www2.asx.com.au/investments/investment-options/etfs