Factor Investing (Value, Momentum, Quality)

A factor is a 'measurable characteristic' that many stocks share in common. For example, 'cheap (value),' 'rose well recently (momentum),' or 'has solid profits (quality).' Factor investing defines these characteristics as rules rather than hunches, and systematically gains exposure to stocks that have those characteristics.

The root of this idea is academia. The '3-factor model' published by Eugene Fama and Kenneth French in 1992–1993 is famous. It held that, beyond the movement of the whole market, two characteristics—'size (small companies)' and 'value (cheap stocks)'—explain differences in stock returns.

In 2015, a 5-factor model that added 'profitability' and 'investment' factors appeared. This 'profitability' is a concept similar to what's commonly called the quality factor. Interestingly, the most famous factor, momentum, didn't actually make it into these models, yet it's one of the most tested phenomena in finance.

Value buys 'stocks that are cheap relative to fundamentals.' You divide the price by a standard like earnings (PER), book value (PBR), or dividends, and pick the side that's cheap relative to the company's substance. Underlying it is the belief that 'buying something good cheaply is ultimately favorable.'

Momentum bets on the 'tendency for stocks that rose well recently to rise a bit more.' It usually looks at the trailing 12-month return but excludes the immediately preceding 1 month in the calculation (this is called '12-1'). You buy the top stocks and avoid the bottom ones.

Quality is about picking 'solid companies.' It favors companies with high, steady operating margins, and Fama-French named this RMW (Robust Minus Weak in profitability). Beyond these, there are more factors like size (small companies) and low volatility.

Factors are attractive because you can expect an 'excess return (premium).' But this premium is not free—it often comes as the price of enduring the pain of trailing the index for years to over a decade.

The representative case is the value factor. Historically, value stocks are said to have beaten growth stocks by about 3 percentage points per year, but in the 2010s it was the opposite. Combining various sources, over this decade value trailed growth by about 5 percentage points per year, and by one estimate it was value 9.9% per year vs growth 14.4% per year. Many interpret that low rates and tech-stock strength worked in growth's favor.

Momentum is even more dramatic. It usually delivers a strong premium, but when the market rebounds sharply from a bottom, it produced huge losses called a 'momentum crash.' There is an estimate that in the 2009 sharp-rebound market, momentum strategies lost roughly over 70% in 3 months, and an analysis that, on a pure momentum portfolio basis, the drawdown that year exceeded 80%.

First, a factor is not a 'magic formula' but a 'statistical tendency that appears only after long endurance.' It's hard to judge a factor as 'dead/alive' based on just a few months' or years' performance. In fact, there was much talk in the 2010s that 'value investing is over,' but there were later periods where value strengthened again.

Second, the more you aim for a premium, the more you must look at maximum drawdown and drawdown duration together. Even something like momentum, with good normal-time performance, can suffer a loss close to being halved in certain phases. The habit of checking 'how much and how long will it fall' as much as 'how much will it rise' matters.

Third, when investing in factors via ETFs/funds, you must calculate the expense ratio (fees), and for overseas factor products, even the exchange-rate effect, to see the return you actually end up with. Directly simulating these elements without hiding them is the fastest way to understand factors.