Factor Investing: A Guide to Smart Beta ETFs and Factor Premiums

For decades, investors had two choices: pick individual stocks (active management) or buy the entire market through an index fund (passive management). Factor investing opened a third path — a systematic, rules-based approach that targets specific characteristics, or "factors," that have historically driven returns. Often marketed under the label smart beta, factor investing has grown into a multi-trillion-dollar segment of the ETF industry.

What Are Investment Factors?

In finance, a factor is a measurable characteristic of a group of securities that explains differences in their returns. Think of factors as the underlying "ingredients" of portfolio performance. Just as a chef can break down a dish into its component flavors, researchers have identified specific traits that explain why some stocks outperform others over long periods.

The concept was pioneered by Eugene Fama and Kenneth French in their groundbreaking 1992 paper, which showed that two factors — company size and value — explained stock returns better than the traditional model based on market risk alone. Since then, researchers have identified additional factors with robust evidence across time periods and geographies.

The Major Investment Factors

Value

The value factor captures the tendency of cheap stocks (measured by price-to-book, price-to-earnings, or other valuation metrics) to outperform expensive stocks over time. The academic evidence for value spans more than 90 years and extends across virtually every stock market studied.

The rationale is debated: some argue value stocks are genuinely riskier (they tend to be distressed companies), while others believe investors systematically overpay for glamorous growth stocks. Regardless of the explanation, the value premium has averaged roughly 3-5% per year historically, though it famously underperformed from 2010 to 2020 before staging a comeback.

Popular value ETFs: Vanguard Value ETF (VTV), iShares Russell 1000 Value (IWD), Avantis U.S. Small Cap Value (AVUV).

Size (Small-Cap Premium)

Smaller companies have historically outperformed larger companies over long periods, though with higher volatility. The small-cap premium was one of the original factors identified by Fama and French. Small companies are less followed by analysts, less liquid, and often riskier — all characteristics that may justify a return premium.

In practice, the size premium is strongest when combined with the value factor. Small-cap value stocks have delivered some of the highest long-term returns of any equity category, though they also experience sharper drawdowns.

Popular small-cap ETFs: Vanguard Small-Cap ETF (VB), iShares Russell 2000 (IWM), Dimensional U.S. Small Cap (DFAS).

Momentum

The momentum factor exploits the tendency of recent winners to keep winning and recent losers to keep losing — at least over 3- to 12-month periods. Stocks that have risen the most in the past year tend to continue outperforming over the next several months. This is one of the strongest and most persistent anomalies in financial markets.

The behavioral explanation centers on investor underreaction: when good news arrives, stock prices adjust gradually rather than instantly, creating a trend that momentum strategies capture. The risk is that momentum can reverse violently — "momentum crashes" like the one in 2009 can wipe out years of gains in weeks.

Popular momentum ETFs: iShares MSCI USA Momentum Factor (MTUM), AQR Large Cap Multi-Style (QKLC).

Quality

Quality stocks are those with strong balance sheets, high profitability, stable earnings, and low debt. The quality factor captures the tendency of these fundamentally sound companies to outperform weaker ones on a risk-adjusted basis. Quality stocks tend to hold up better during market downturns, providing a degree of defensive protection.

Quality is measured through metrics like return on equity, earnings stability, debt-to-equity ratio, and gross profit margins. Warren Buffett's investment philosophy is essentially a quality-factor strategy: buy excellent businesses at reasonable prices.

Popular quality ETFs: iShares MSCI USA Quality Factor (QUAL), Invesco S&P 500 Quality (SPHQ).

Minimum Volatility

The minimum volatility (or low-vol) factor is perhaps the most counterintuitive: stocks with lower volatility have historically delivered higher risk-adjusted returns than their high-volatility counterparts. This contradicts the basic finance principle that more risk should mean more return.

Explanations include the "lottery effect" (investors overpay for volatile stocks hoping for big wins) and leverage constraints (conservative investors bid up low-volatility stocks because they cannot use leverage to amplify returns). Minimum volatility strategies typically lag in strong bull markets but protect capital during downturns.

Popular low-vol ETFs: iShares MSCI Min Vol USA (USMV), Invesco S&P 500 Low Volatility (SPLV).

Dividend Yield

While closely related to the value and quality factors, the dividend yield factor specifically targets companies that pay above-average dividends. High-dividend stocks tend to be mature, profitable companies, and the regular income stream can provide psychological comfort during downturns. The dividend factor overlaps significantly with value and quality, so combining it with those factors may not add as much diversification benefit.

Academic Evidence and Real-World Performance

The evidence for factor premiums is among the most extensively researched topics in finance. Key findings include:

• Persistence — Factors like value, momentum, and size have been documented across 100+ years of U.S. data and in international markets.
• Cyclicality — No factor works all the time. Value and momentum, for example, tend to perform in opposite market environments. Factor premiums can disappear for years before reasserting themselves.
• Diminishing returns — As factor investing has become more popular, some premiums may have shrunk. More capital chasing the same anomaly can reduce the excess return available.
• Implementation costs — Factors with high turnover (like momentum) incur higher trading costs, which can eat into theoretical premiums.

The critical insight is that factor premiums are compensation for bearing specific risks or exploiting behavioral biases. They are not free money — they require patience through long periods of underperformance and the discipline to stick with the strategy when it is not working.

How to Implement Factor Investing With ETFs

The most accessible way to gain factor exposure is through exchange-traded funds designed to target specific factors. Here are three implementation approaches:

Single-Factor ETFs

Hold individual ETFs that each target one factor. This gives you maximum control over your factor tilts and allows you to adjust exposures over time. The downside is more complexity and the temptation to abandon underperforming factors.

Multi-Factor ETFs

A single ETF that combines multiple factors in one portfolio. These products handle the factor blending and rebalancing for you, typically targeting value, momentum, quality, and size simultaneously. Examples include the Goldman Sachs ActiveBeta ETFs and JPMorgan Diversified Return funds.

Core-Satellite Approach

Hold a broad market index fund as your core (70-80% of the portfolio) and add factor tilts around the edges (20-30%). This captures most of the market return while adding a modest factor exposure. It is a pragmatic middle ground that limits tracking error relative to the broad market.

Building a Multi-Factor Portfolio

One of the most powerful aspects of factor investing is that factors tend to have low correlation with each other. Value and momentum, for instance, often perform well in opposite market environments. This means combining factors can smooth returns and improve the Sharpe ratio of your overall portfolio.

A sample multi-factor allocation might look like:

• 40% broad market index (core exposure)
• 15% value (small-cap value for stronger tilt)
• 15% quality (defensive, lower drawdowns)
• 15% momentum (capturing trends)
• 15% minimum volatility (downside protection)

MavenEdge Finance includes factor-based asset class buckets in its asset class analysis, making it straightforward to see how different factor tilts affect your portfolio's risk-return profile.

Factor Investing Pitfalls to Avoid

Performance Chasing

The most common mistake is adding a factor after it has performed well and dropping it after it underperforms. Factor premiums are cyclical — the time when a factor looks worst is often the time when expected future returns are highest.

Overpaying for Complexity

Some smart beta products charge high expense ratios for relatively simple factor tilts. Compare the expense ratio against what you are getting — a factor ETF charging 0.50% needs to deliver meaningful outperformance to justify the cost over a 0.03% total market fund.

Ignoring Tax Implications

Factor strategies with high turnover (especially momentum) generate more taxable events. Consider holding high-turnover factor funds in tax-advantaged accounts like IRAs and 401(k)s.

Too Many Factors, Too Little Conviction

Holding six or seven single-factor ETFs can result in a portfolio that looks very similar to a simple market-cap index fund — but with higher costs and more complexity. If you are going to tilt toward factors, do so with enough conviction to make a difference.

The Bottom Line

Factor investing bridges the gap between passive indexing and active stock picking, offering a systematic, evidence-based approach to pursuing higher returns. The key factors — value, size, momentum, quality, and minimum volatility — have decades of academic research supporting their existence, though none works consistently in every market environment.

Success with factor investing requires patience, discipline, and realistic expectations. Factor premiums are real but cyclical. The investors who benefit most are those who choose their factor tilts based on a sound understanding of the underlying rationale, implement them cost-effectively through ETFs, and stick with their strategy through the inevitable periods of underperformance.