By Harry Prabandham · Updated September 28, 2026
Investing & Markets
Factor Investing and Smart Beta: How It Works and the Risks
Factor investing tilts a portfolio toward traits like value, size, momentum, quality or low volatility using rules-based indexes. Results vary for years.
Factor Investing and Smart Beta: How It Works and the Risks
1 / 6
What is factor investing?
- Factors are characteristics, such as valuation or company size, that help explain why some groups of stocks have returned more than others.
- Factor strategies tilt a portfolio toward those characteristics using published, rules-based methods.
- Smart beta funds track indexes weighted by something other than market capitalization.
- They sit between traditional index funds and discretionary active management.
Try Our Free Tools
Full Guide
What is factor investing?
- Factors are characteristics, such as valuation or company size, that help explain why some groups of stocks have returned more than others.
- Factor strategies tilt a portfolio toward those characteristics using published, rules-based methods.
- Smart beta funds track indexes weighted by something other than market capitalization.
- They sit between traditional index funds and discretionary active management.
What does the academic research show?
- Eugene Fama and Kenneth French's 1993 three-factor model added size and value to overall market exposure.
- Mark Carhart's 1997 work added momentum, and Fama and French added profitability and investment factors in 2015.
- Researchers documented historical return premiums for these factors, but the premiums have varied widely by period.
- Researchers disagree on whether premiums reflect compensation for risk or investor behavior, which affects whether they may persist.
The major factors
- Value: stocks priced low relative to measures such as book value, earnings or cash flow.
- Size: smaller companies, which tend to be more volatile than large ones.
- Momentum: stocks with strong returns over roughly the past year relative to peers.
- Quality and low volatility: profitable, financially sound companies, and stocks with smaller price swings.
Why can factor strategies lag for years?
- Value stocks trailed growth stocks for much of the 2010s.
- Any single factor can underperform the market for long stretches, which tests an investor's patience.
- Premiums may shrink as more money pursues the same strategies.
- Combining factors can smooth results because factors don't always move together, though a multifactor fund can still lag.
What are the costs and risks?
- Factor funds are usually cheaper than active funds but more expensive than market-cap index funds.
- Methodologies differ, so two funds with the same factor label can hold very different stocks.
- Tilts can concentrate a portfolio in particular sectors or stocks.
- Higher-turnover strategies, especially momentum, can create taxable gains, and backtested results may not repeat.
Key takeaways
- Factor investing applies academic research through rules-based portfolios.
- Historical premiums have been real but uneven, with long periods of underperformance.
- Compare methodology, cost, concentration and turnover, not just the factor label.
- Factor tilts can also be applied through direct indexing in taxable accounts.
Related Topics
Investing & Markets
Value vs. Growth Investing: How the Two Styles Differ
Value stocks trade at low prices relative to earnings or book value; growth stocks at premiums for expected growth. Leadership between them shifts.
Investing & MarketsSmall- and Mid-Cap Stocks: What Company Size Means for Risk
Small- and mid-cap stocks are shares of smaller public companies. They diversify by size but tend to be more volatile and less liquid than large caps.
Investing & MarketsDirect Indexing: Owning an Index Stock by Stock
Direct indexing holds an index's stocks individually in your own account, allowing loss harvesting and exclusions a fund cannot offer, at added cost.