Factor investing is a passive quantitative strategy that involves investing in certain “factors” that tend to outperform over long periods of time. The three most popular factors are momentum, size and value. Momentum is the tendency for recent outperformers to continue to outperform, size is the tendency for small-cap stocks to outperform, and value is the tendency for cheap stocks to outperform. These factors have done well in the past, but will they continue to do so in the future?

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The above chart shows the performance of SPDR S&P 500 (SPY) against three iShares factor ETFs. These ETFs were launched in April of this year and so are still fairly new, however the factors on which they are based come from research by quantitative investment firms and academics over the last four decades. VLUE has outperformed the S&P since inception while the other two funds have lagged.

Like all good investment ideas, the biggest worry is for a trade to become crowded, driving up prices and limiting future returns. Factor investing depends on the continued mispricing of these types of stocks. If the market catches on, future outperformance is unlikely. All four factors have gone through extended periods of underperformance, so buy-and-hold investors should expect to trail the market at times, but to make up for it in the long-term.

An important issue to consider with factor ETFs is diversification. The SIZE and VLUE ETFs both invest in 600 stocks from the MSCI US Index, while MTUM and QUAL invest in 124. The much higher number of holdings for SIZE and VLUE is likely to result in a lower tracking error to the broad indices than MTUM and QUAL.

Factor ETFs can be a way to add some “smart beta” to your portfolio, but be sure to take a look at each fund’s top holdings to ensure that you aren’t overexposing yourself to names you already own.

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