If markets are mostly efficient (as EMH suggests), why do certain characteristics like "cheap stocks" or "small companies" persistently outperform? Either the market is less efficient than it seems, or these factors represent genuine risks that deserve compensation. Decades of academic research — and trillions of dollars of investment — have been built on answering this question.
The major equity factors
| Factor | Definition | Proposed reason |
|---|---|---|
| Value | Cheap stocks (low P/B, P/E, P/CF) | Distress risk; behavioural overreaction |
| Size | Small-cap stocks outperform large-cap | Liquidity risk; less analyst coverage |
| Momentum | Recent winners continue outperforming | Behavioural: underreaction to news |
| Quality | High profitability, low debt, stable earnings | Mispriced by market; defensive in downturns |
| Low Volatility | Low-beta, low-vol stocks | Anomaly — contradicts CAPM directly |
The Fama-French Three-Factor Model
In 1992, Fama and French showed that adding size (small vs large) and value (cheap vs expensive) to CAPM explained stock returns far better than beta alone. This became the Fama-French Three-Factor Model. Later work added momentum (Carhart, 1997) and profitability/investment factors (Fama-French Five-Factor, 2015), each adding explanatory power.
The factor decay problem
Here's the uncomfortable truth: once a factor is published and widely known, investors pile in and arbitrage away the premium. The value premium has significantly weakened post-publication. Momentum requires high turnover and suffers severe crashes. Low-volatility strategies have become crowded. Whether historical factor premiums persist into the future is one of the most contested questions in finance.
Smart Beta ETFs
Factor investing is now accessible to retail investors through "smart beta" ETFs that systematically tilt towards one or more factors. Examples: iShares MSCI World Value Factor ETF, Invesco S&P 500 Momentum ETF. Costs are between pure passive (0.03%) and active management (0.5–1.5%), typically 0.2–0.4%.
What this means for you
Factor investing offers a middle path between pure index investing and active management. The evidence for factors is real, but their future persistence is uncertain. If you add factor tilts to a portfolio, diversify across multiple uncorrelated factors (value + momentum work well together because they tend to be negatively correlated) and be prepared to hold through extended periods of underperformance — which can last 5–10 years even for legitimate factors.