{"id":17718,"date":"2019-05-03T00:00:05","date_gmt":"2019-05-02T22:00:05","guid":{"rendered":"https:\/\/gerd-kommer.de\/blog\/factor-investing-the-basics\/"},"modified":"2025-12-19T19:07:55","modified_gmt":"2025-12-19T18:07:55","slug":"factor-investing-the-basics","status":"publish","type":"post","link":"https:\/\/gerd-kommer.de\/en\/blog\/factor-investing-the-basics\/","title":{"rendered":"Factor investing \u2013 the basics"},"content":{"rendered":"

By Gerd Kommer<\/a>\u00a0and Alexander Weis<\/a><\/em><\/p>\n

Note: The data basis in this blog post was expanded in November 2021 to include the years 2019 and 2020.<\/em><\/p>\n

“Passive investing” \u2013 i.e. very broad diversification with market-neutral index funds on a buy-and-hold basis \u2013 is probably one of the world’s greatest success stories in capital market investment over the past 50 years. But no matter how impressive an innovation is, there will always be someone who, even in the face of its great success, will ask further questions and probe even deeper. This has also been the case with “passive investing” with market-neutral index funds over the past twenty years or so. (The term “market neutral” is used differently in the specialist literature than in this blog post, where it generally refers to long-short strategies that aim to eliminate overall market risk).<\/em>\u00a0The research findings of several hundred financial economists in recent decades have led to a variant of the passive investing approach, namely “factor investing”, often also referred to as “Smart-Beta investing”.<\/p>\n

What are “factors” or “factor premiums”? Factor premiums are statistically identifiable drivers of return and risk in an asset class such as stocks, bonds or real estate. They explain a large part of the risk-return profile within the asset class. Statistically, the return and risk of a securities portfolio can only be explained by more than 90% if the “factor exposure” in this portfolio is identified and measured \u2013 i.e. how strongly a portfolio is exposed to these factor premiums. A comparison: The number of hours students spend studying for a math exam statistically explains a significant portion of the deviation of students’ grades from the class average. In this example, “number of hours” is the factor. Other factors, such as a student’s IQ, explain further parts of the statistical deviation from the average.<\/p>\n

In this first part of our blog trilogy on factor investing in the stock asset class, we first look at the basics. In the second part, which will be published next month, we describe the smartest way to introduce factor premiums into your portfolio and what you need to bear in mind.<\/p>\n

The best-known factor premium for stocks is the “small-size premium”, often just called the “size premium” or “small-cap premium”. It states, quite simply, that small listed companies (small in terms of market capitalization) produce higher stock returns on average than large companies or the total market (see table below for the period 1975 to 2020).<\/p>\n

Through purely mechanical, disciplined overweighting<\/em> of factor premiums in a portfolio, it is possible to generate an additional return after costs and taxes compared to the total market; hence the term “premium”. In terms of small caps, \u201coverweighting” would mean increasing their percentage share in the portfolio above the share that small caps have in a market-neutral “total market portfolio” (small caps account for around 15% of the total market capitalization of the world stock market). “Overweighting” sounds more complicated than it is, because this kind of overweighting can be achieved quite simply by buying a small-cap ETF.<\/p>\n

Exposure to the small cap premium is therefore not for those who have small caps in their portfolio to a “normal extent”, but only for those who have small caps in their portfolio to a greater<\/em> extent than is already the case in the underlying asset class universe.<\/p>\n

Factor investing is essentially passive investing, i.e. the renunciation of active “stock picking” (targeted selection of individual stocks; more generally, “asset picking”) or active “market timing” (tactical “in-out” in relation to entire market segments).<\/p>\n

Factor investing differs from traditional passive investing in one important respect. With factor investing, the individual securities in the portfolio are not weighted purely according to their market capitalization, but this weighting principle is softened, e.g. by overweighting small cap stocks.<\/p>\n

The best-known and, in our opinion, best-established premiums in the scientific literature are listed below:<\/p>\n