What is Factor Investing?

1Definition and Context

Factor investing is a strategy that selects securities based on characteristics ("factors") associated with historically superior returns. In practice, a diversified portfolio is built following fixed rules (e.g., favoring small companies or those with a low price/book ratio). The goal is to obtain a factor premium, which is an average excess return compared to the market, by exploiting the risk factors that drive returns. In finance, this approach stems from the extensions of the CAPM: originally, the CAPM predicted that the expected return depended only on exposure to the market (β factor), while subsequent models add other empirically validated over decades of academic research, particularly in US and developed markets data.

2Evolution of Pricing Models

The CAPM (Capital Asset Pricing Model) of the 1960s is a one-factor model: the expected premium of an asset is proportional to its market β. In other words, those with β=2 obtain (on average) twice the market risk premium. Already in the CAPM model, it was understood that those who have a high exposure to market risk (high β) should receive a higher return in exchange.

In 1993, Fama and French introduced a 3-factor model that expands the CAPM by adding size and value. The empirical idea was that small companies (small cap) have historically had higher returns and that "value" stocks (low price/book value) outperform "growth" stocks. Therefore, in addition to the market, the return difference of Small minus Big (SMB) and High minus Low (HML) portfolios is considered to capture these historical anomalies.

In 2015, Fama and French proposed a 5-factor model, adding two new quality factors: profitability and investment. In practice, they select the most profitable companies (high operating profitability) and those that invest less in total assets. The data show that companies with high profitability tend to outperform, while those that increase their investment significantly (high asset growth) have below-average returns. These two factors are often summarized as "quality" factors in investing.

3The Five Main Factors

4Example (CAPM Calculation)

5Formulas of Multifactor Models

6Factor Premium and Investing in Factors

The factor premium is defined as the additional return obtained from exposure to a specific risk factor. In practice, it is the historical average of the extra results of strategies based on a factor compared to the general market trend. For example, if a portfolio based on value stocks yields an average of 1% more per year than the overall market, it is said that the Value factor has a premium of 1%.

Investing in factors means strategically building the portfolio to have exposure to the desired factors. Instead of aiming for a generic index (e.g., broad stock index), securities (or ETFs) that emphasize a given characteristic are chosen. For example, a "Value" ETF selects stocks with below-average fundamentals, while a "Quality" ETF favors profitable companies. This approach serves to improve diversification and to obtain generally superior returns in the long term, exploiting empirically effective factors.

7Alpha and Multifactor Models

Alpha is the "extra" return (positive or negative) of a security or portfolio compared to what is predicted by a pricing model (e.g., CAPM). In practice, if a portfolio obtains more (or less) than the expected return from CAPM, that excess is the α. Traditionally, α was interpreted as a measure of manager skill or market inefficiencies. However, much of that so-called α is now explained by exposure to additional factors in multifactor models. In other words, an "anomalous" return compared to the CAPM can simply be due to the presence of a large positioning on size, value, quality factors, etc. Using models with more factors (3 or 5 factors), the residual α is reduced, because the model explains more return variation than the simple CAPM.

8Real Examples for European Investors

UCITS factor ETFs are accessible tools to apply these strategies in Europe. For example:

• Size – ETFs on European small caps. There are funds such as the Xtrackers MSCI Europe Small Cap UCITS ETF or the SPDR MSCI Europe Small Cap Value Weighted UCITS ETF, which replicate MSCI indices dedicated to small caps. These ETFs overweight low capitalization companies (size factor).
• Value – ETFs on European value stocks. For example, the iShares MSCI Europe Value Factor UCITS ETF and the Amundi MSCI Europe Value Factor UCITS ETF follow indices with low P/B stocks. These funds aim to capture the value premium by containing undervalued stocks.
• Quality/Profitability – ETFs on profitable stocks. For the quality factor (which reflects company profitability), there are ETFs such as the iShares MSCI Europe Quality Factor UCITS ETF or the Amundi MSCI Europe Quality Factor UCITS ETF. These select companies with high ROE and stable earnings.
• Investment/Conservative – ETFs on "conservative" stocks. The iShares MSCI Europe Conservative Factor UCITS ETF, for example, invests in companies with low asset growth, in line with the investment factor (CMA).
• Multi-factor – ETFs that combine multiple factors. There are also "smart beta" ETFs that follow multifactor indices (for example, the iShares STOXX Europe Equity Multifactor UCITS ETF), simultaneously diversifying across size, value, quality, momentum, etc.

These examples illustrate how, through UCITS ETFs available in Europe, an investor can obtain selective exposure to various factors. Each fund mentioned allows exposing the portfolio to a specific rewarding risk factor, in line with one's investment profile.