Factor

What Is a Factor?

In investing, a factor is a characteristic shared by many securities that appears to influence how their prices move and how much return they generate. Examples include a company's size, its valuation, its recent price trend, its profitability, and how much its price fluctuates. Researchers use factors to explain why stocks behave differently from one another, rather than treating each stock as entirely unique.

How Factors Work

Researchers have identified several factors that have been linked to differences in long-term returns across groups of stocks. Commonly discussed examples include:

• Value, which compares lower-priced stocks relative to fundamentals such as book value or earnings with higher-priced ones
• Size, which compares smaller companies with larger ones
• momentum, which compares stocks that have recently performed well with those that have performed poorly
• Quality, which compares companies with stronger profitability and balance sheets against weaker ones
• Low volatility, which compares steadier stocks with more erratic ones

A factor's return is the performance difference between these groups. A historical link between a factor and returns does not guarantee that the link will continue.

Factor Models

A factor model breaks a security's return into two parts: the portion explained by exposure to common factors, and the portion specific to the individual company. In the early 1990s, Eugene Fama and Kenneth French proposed a three-factor model that added size and value to the broad market risk factor, and it became influential in academic and professional research. Using regression analysis, an analyst can estimate how sensitive a portfolio is to each factor, which is often called its factor exposure.

Why It Matters to Investors

Understanding factors can help an investor see what a portfolio is actually exposed to. Two funds that look different may hold similar factor exposures, and a portfolio concentrated in one factor may perform very differently when that factor falls out of favor. Factor investing refers to strategies that deliberately tilt holdings toward certain factors. Factor performance varies across periods, and past results may not repeat. Reading a fund's methodology explains how it defines and measures its factors. Factors are one of several tools for understanding diversification, not a complete measure of it.