Factor Investing: Using Value and Momentum to Boost Returns

In today’s complex markets, investors seek strategies that offer both pursuit of profit and protection against volatility. Factor investing achieves this by isolating key drivers of returns and risks, allowing a disciplined approach that transcends mere stock picking.

By combining the value factor’s emphasis on undervalued securities with the momentum factor’s trend-following edge, one can craft a portfolio designed to capture a compelling long-term performance premium while mitigating the emotional biases that derail many market participants.

What Is Factor Investing?

At its core, factor investing identifies characteristics—known as factors—that systematically explain differences in risk and return across assets. While traditional analysis focuses on individual securities, factor strategies target broad, persistent effects.

These effects include statistically observed premiums for stocks that exhibit traits such as low valuation, strong earnings quality, or price momentum. Investors implement these exposures via index-based products or custom portfolios, adhering to a systematic, rules-based investment methodology to ensure consistency and discipline.

The Value Factor: Buying Underpriced Opportunities

The value factor rests on a simple premise: investors often overreact to bad news, pushing stock prices below their intrinsic worth. By selecting stocks with attractive ratios—such as price-to-earnings, price-to-book, or dividend yield—value strategies position portfolios to benefit when fundamentals improve.

Historically, value stocks have delivered a persistent premium over growth-oriented names as market sentiment oscillates. While performance can lag during extended growth cycles, disciplined adherence to valuation thresholds often yields strong rewards once mean reversion takes hold.

Key metrics frequently used include:

• Price-to-Book (P/B) and Price-to-Earnings (P/E)
• Price-to-Sales and Price-to-Cash-Flow
• Dividend Yield and Forward Free Cash Flow

The Momentum Factor: Riding Market Trends

Momentum strategies capitalize on the tendency of winning stocks to continue outperforming. By ranking securities based on trailing returns—commonly over 3- to 12-month windows—investors buy strength and sell weakness.

Although momentum can be vulnerable to sudden reversals, its persistently positive premium, when combined with robust risk controls, has rewarded disciplined practitioners for decades. Behavioral explanations point to investor underreaction to information and herding effects.

Effective momentum requires fast execution and strict stop-loss rules to mitigate cyclical drawdown risks. It often complements value by performing well when value lags, thanks to their typically low correlation.

Blending Value and Momentum: Synergy in Action

By combining these two factors, investors can harness the strengths of each while smoothing out individual underperformance periods. Value thrives when markets reward fundamentals, whereas momentum excels amid strong trends.

Several studies show that a balanced blend of value and momentum offers improved risk-adjusted returns compared to either factor alone. This combination embodies a powerful emotional anchor for discipline, reducing the temptation to abandon one approach when it temporarily underperforms.

• Low historical correlation smooths portfolio volatility
• Enhanced upside capture in varied market regimes
• Reduced drawdowns when one factor is out of favor

Building a Factor-Based Portfolio

Constructing a factor portfolio involves selecting exposure levels, setting sector and position caps, and determining rebalance frequency. Typical approaches include single-factor allocations, tactical shifts based on market conditions, or multifactor blending.

Important steps include rigorous data sourcing, transparent scoring models, and the application of constraints to diversify unique factor-specific risks. Portfolios often rebalance semi-annually or quarterly to maintain targeted exposures and manage turnover.

• Define investment universe and screening criteria
• Assign composite scores for each factor
• Impose sector and individual security limits
• Schedule periodic rebalancing

Risks and Practical Considerations

While factor investing offers compelling advantages, it is not immune to market cycles. Each factor can endure multi-year stretches of underperformance, posing challenges to patience and conviction.

Investors must account for transaction costs, tax impacts, and the potential for crowded trades, particularly in popular factor-indexed products. Moreover, true outperformance hinges on strict adherence to rules, avoiding subjective overrides that undermine the persistent drivers of asset returns.

Key best practices include:

• Blend factors to reduce idiosyncratic risk
• Maintain transparent, repeatable methodologies
• Monitor turnover and manage trading costs
• Stay disciplined through performance cycles

Conclusion

Factor investing, particularly through the combination of value and momentum, empowers investors with a robust, evidence-based framework. By targeting robust, pervasive, investable factors and committing to disciplined implementation, one can achieve smoother returns and enhanced growth potential.

This strategic approach transcends short-term noise, offering a roadmap for investors seeking to navigate market uncertainties. Embrace the synergy of value and momentum to build portfolios that stand the test of time and market volatility.