Factor investing

Factor investing builds portfolios around specific, well-documented characteristics of stocks or other assets that have historically been associated with different returns — such as value (cheap relative to fundamentals), momentum (recent strong performers), size (smaller companies), quality (profitable, low-debt companies), and low volatility — rather than picking individual securities on their own merits.

Factors are identified through regression-based models that decompose returns into exposure to each factor plus an unexplained residual, extending the single-factor market model used to estimate beta and alpha. A portfolio can be built to tilt toward one or more factors systematically, which is why the approach is often called "smart beta": it aims to capture a specific, rules-based exposure rather than relying on manager judgment.

Practitioners use factor investing to diversify sources of return beyond broad market exposure and to explain, after the fact, why a manager's results diverged from fundamental analysis-driven expectations. A common pitfall is factor crowding — when a factor becomes popular, its future returns can shrink or reverse as more capital chases the same trades — and another is overfitting a factor to historical data during backtesting without a sound economic rationale for why it should persist.