How do you know if a stock fund is any good? A manager might beat the market over some period, but was it due to skill, or luck? For a long time, investors didn’t have a good way to explain why some stock portfolios performed better than others. There was no framework to predict or break down performance in a consistent way.
That started to change when academics introduced the idea of factors, or broad characteristics that help explain stock returns. The first and most basic was the market factor (1960s): the idea that any stock’s return largely depends on its sensitivity to how the overall market moves, a measure they called "beta."
The market always has a beta of 1, so as an example, if a stock’s beta is 1.1, we’d predict that it returns 1.1x the market, i.e., if the market is up 10%, we’d expect that stock to be up 11%.
While this was a decent model, it was incomplete. Many stocks still had unexplained returns, which were called "alpha." Using the same example, if the predicted stock return was 11%, but the actual was 12%, that 1% difference is “alpha”.
Over time, researchers have tried to uncover additional factors that could account for this “alpha”. Fast forward to today, these factors have become a key part of how many investors evaluate managers and build portfolios.
What Are Equity Factors?
Equity factors are quantitative traits that have historically helped explain why individual stocks deliver higher returns than the market.
It’s easy to find patterns in historical data, so there are several “tests” these factors must pass for us to have confidence in them:
- They’ve worked across different countries and over time periods in and out of sample.
- They’ve shown consistent performance using multiple definitions of the factor.
- They’ve been explained by both behavioral and economic theories.
These give investors’ confidence that they aren’t just flukes of history. Each factor is supported by a mix of economic logic and human behavior. Human behavior refers to investors making consistent mistakes, overreacting, underreacting, and chasing trends, and those patterns show up in the data. Other explanations are “risk-based”, meaning the returns make sense as compensation for taking on certain kinds of discomfort when investing.
Five of the most well-known equity factors are:
- Value: Involves buying stocks that are cheap relative to fundamentals like earnings or book value, often because they are out of favor.
- Momentum: Focuses on stocks that have recently performed well, as winning stocks tend to keep performing in the near term.
- Quality: Targets companies that are profitable, stable, and financially healthy, often with strong balance sheets and consistent earnings.
- Small Size: Tilts toward smaller companies, which historically have delivered higher returns over long periods despite greater volatility.
- Betting Against Beta: Prefers steady, lower risk stocks.
Each one of these factors is crafted by buying the stocks that exhibit the factor (a low PE stock for value) and selling short a stock that does the opposite (a high PE stock for value).
Why This Matters for Investors
The way to intuit these factors is to think of them as “investing styles”. Take Warren Buffett for example. We know he likes to buy good businesses at low prices. Thinking through a factor lens, we’d say he’s probably bought stocks that tilt towards the quality factor (“good business”) and the value factor (“low prices”). We can measure exactly how much he tilts towards those factors, and if he does to any others as well, which many have done.
Said another way, factors allow us to “reverse engineer” how a stock manager picks stocks. In the past, you’d hire a manager for their “secret sauce”, hoping that they are simply smarter than other market participants. Today you can measure exactly what factors they tend to invest in, and if there’s any extra performance (alpha) after accounting for them. If there’s not, you can go buy the factors directly for much lower fees. All the active performance, a fraction of the cost.
Factor bring more structure and clarity to portfolio construction. They help explain performance, reduce costs, and build more thoughtful investment strategies grounded in evidence, not guesswork. Factors are an integral part of our investment selection process and are targeted in our investment portfolios. If you have questions about factors, stock fund performance, or portfolio management in general, please give us a call.
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PAST PERFORMANCE IS NOT A GUARANTEE OF CURRENT OR FUTURE RESULTS. Examples of historical information included in this presentation do not, nor are they intended to, constitute a promise of similar future results. Specific client portfolio allocations, risks and returns can and may deviate from these examples depending on accounts and types of investments available through each account. Future market views by WJ Interests, LLC may vary significantly from the historical examples presented herein and no one receiving this summary should assume that WJ Interests, LLC will be able to replicate successful views in the future.
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