Momentum
Research has found that a stock's performance over the medium term can forecast its performance in the future. Stocks that have performed well tend to continue to perform well and vice versa.
Momentum investing appears to be a quirk of market behavior. Investors may not give credence to a company's improving fundamentals or trends until it's already started to outperform the market. But once it's outperformed and has started getting the attention of investors, investors will pile into the stock, building further momentum in the stock price. That cycle can continue indefinitely as long as the company continues to outperform and produce strong financial results.
The momentum factor also carries a higher risk than other factor-based strategies. That's because an earnings miss on a momentum stock can completely kill the momentum built up over time, immediately putting the momentum in reverse.
Quality
Everyone wants to invest in "quality" companies. For the purposes of factor investing, a quality company is one with stable income and cash flow and a strong balance sheet without excessive debt, producing high earnings relative to its peers. If a company has those characteristics, it's a good sign it has a durable competitive advantage.
Competitive advantages come in all forms, but the results of those competitive advantages are the same. A company with a competitive advantage can produce higher profit margins than its competitors. Furthermore, those advantages are very tough to overcome, which means the company will likely remain more profitable than the competition for years. As a result, it should produce better earnings results and outperform the market over the long run.
Volatility
Stocks with less volatile prices tend to outperform more volatile stocks over time when adjusted for risk. By investing solely in low-volatility stocks, investors can match market returns but reduce the variance in portfolio value.
The outperformance of low-volatility stocks could be attributed to certain other factors. For example, value stocks tend to have lower price volatility. Regardless, finding stocks with less volatility than the overall market should help investors find stocks that outperform when adjusted for risk. That can lead to a less bumpy ride for investors looking to live off their portfolios.
Factor investing in the real world
Factor investing has grown in popularity over the past decade or so, and financial institutions have developed products to facilitate factor investing. It's now possible to buy an exchange-traded fund (ETF) or mutual fund that focuses on a specific factor or a combination of multiple factors.
