Most investors spend their time asking which stocks to buy. But maybe that’s not the right question to ask. Maybe a better question is: what actually makes a stock worth owning in the first place?
That’s the question that factor investors try to answer. Instead of treating stocks as a monolith—or relying on a single metric like the P/E ratio—they look for the underlying characteristics that they believe truly drive performance. Because once you understand those traits, you can start to see what’s really behind price movements.
Deconstructing stock performance
Back in the 1960s, the investing consensus was that risk was the only driver of return, specifically, market risk, or what Wall Street calls beta. If an investor sought higher returns, they simply had to accept more volatility relative to the overall market.
Then came a couple of wide-eyed academics who, thankfully, couldn't leave well enough alone. Nobel laureates Eugene Fama and Kenneth French found that specific traits, like how cheap a stock is relative to its book value or how small its market cap, could potentially explain returns better than market risk alone. And with that research, factor investing was born, and the simple world of beta was never the same.1
Fast forward to 2026, and factor investing has expanded well beyond what Fama and French imagined. It’s now a multi-trillion-dollar corner of investment management that identifies attributes that can impact returns.
Sounds a lot like active management, right? The reality is that factor investing sits somewhere in between active and passive. The passive side follows a set of rules, and the active side is the deliberate move away from standard market-cap-weighted indices (like the S&P 500) in pursuit of outperformance.
The Fab 5 of Factor Investing
When Fama and French began their research, they identified three factors they believed explained stock returns, or what became known as the Fama-French three-factor model. Years later, the academic duo expanded that framework from three to five.2
But since then, the field has grown almost exponentially, and today, there’s no single agreed-upon set of factors. Most factor investors have their own preferred mix—some borrowed from Fama-French and others kept firmly proprietary.
For us at Motley Fool Asset Management, we factor value, momentum, quality, size, and “growth at risk.”
Value: The beauty of a bargain
This might be the mother of all factors. Value investing is rooted in the belief that inexpensive stocks relative to their fundamental value (based on analysis of earnings, dividends, book value, etc.) should outperform expensive stocks over the long term.
That doesn’t mean value investors are scooping up lemons on sale. Instead, the value factor, if applied correctly, separates what it believes is a true bargain from an inexpensive company on its last legs.
Momentum: The law of financial motion
While Sir Isaac Newton might have been a bad investor (he lost his shirt investing in the South Sea Company)3, his laws of physics apply well to the market. Momentum factor investing relies on the persistence of price trends. It is the belief that assets that have performed well in the recent past should continue performing well in the near future.
This sounds counterintuitive to the classic "buy low, sell high" advice. Momentum is more like "buy high, sell higher." It capitalizes on behavioral biases, including the tendency of investors to be slow to react to new information. Because of this bias, trends can extend longer than they should.
Quality: The corporate straight-A student
Quality investing targets companies with healthy balance sheets, stable earnings growth, and high profitability. Fama and French considered a part of quality something called Robust Minus Weak (RMW), which represents the difference in returns between companies with high, or robust, operating profitability and weak operating profitability.4
Stocks incorporating these characteristics are the type that anyone can own and sleep well at night. They are the “boring,” reliable compounders that might not double in a week but are unlikely to go belly up either. In turbulent economic times, investors have flocked to quality.
Size: Small fish, big ponds
The size factor stems from the historical observation that small-cap stocks have tended to outperform large-cap stocks over long periods.5 The logic is that smaller companies are nimbler, have more room to grow, and are riskier. Therefore, investors demand a premium for holding these stocks.
“Growth at risk”: Not growth at all costs
We think of “growth at risk” as a remix of the CMA (Conservative Minus Aggressive) factor from the Fama-French five-factor model, which basically looks at the intangibles that don’t show up on a balance sheet. We mean things like R&D, brand value, and processing power. You know, the things that are too squishy or risky to have a line item on a 10-K. But that’s actually the point: because they’re hard to measure, the market may often misprice them, which is why there is the belief they can earn higher returns.
A common term for these companies is “asset-light.”
Smart Beta vs. Factor Investing
You will often hear the terms factor investing and smart beta used interchangeably, and even though they’re similar, they aren’t the same thing.
Think of it this way: Factor investing is a philosophy, and smart beta is a vehicle.
- Factor Investing is the academic concept; the decision to target Value or Momentum.
- Smart Beta is a label often applied to ETFs and funds that invest based on factors.
So when you hear about something like a smart beta ETF, that’s just a fund that uses a rule-based system to capture a specific factor. It often follows an index, but not in the traditional sense of an S&P 500 ETF. Instead, a smart beta ETF can track an index that weights companies based on how inexpensive they are or how much momentum they have.
Just remember: Not all smart beta strategies are created equal. Many still rely on decades-old metrics that haven't kept pace with how modern businesses actually create value, which may create an opportunity for a potentially smarter approach… a Foolish approach.
So why use factors?
Potential for excess returns: The primary allure is alpha or outperforming the market (or your benchmark index). By tilting a portfolio toward factors like value or momentum, investors hope to capture the historical premiums associated with those characteristics.
True diversification: Many investors think they are diversified because they own 20 different stocks. But if all 20 are expensive, high-growth tech stocks, they really are betting on a single factor. If that factor crashes, the whole portfolio could sink. Oftentimes, factors have low correlation with each other. Think Value and Momentum.
Risks and realities of factor investing
Before you rush to reallocate your portfolio, remember that there is no free lunch in investing and that all investing involves risk and may lose money. If factors worked all the time, everyone would be a factor investor, and the advantage would disappear.
Cyclicality: Factors can go through excruciating periods of underperformance. From 2011 to 2021, US growth stocks outperformed US value stocks by an average of 7.8% per year. Such eye-watering underperformance of value had been atypical historically.6 Holding a factor strategy requires immense discipline when it’s out of favor.
Behavioral Risk: The math of factor investing is considered solid, but the psychology is hard. The biggest risk may be emotional. Consider the investor who dumped their value-tilted fund in 2020 after a decade of watching growth stocks lap them, only to miss value's powerful comeback in 2022. Discipline isn't just a nice-to-have in factor investing. It's the whole game.
Implementation Costs: Smart beta and factor strategies often have higher turnover (buying and selling) than a plain vanilla index fund. This can lead to higher transaction costs and tax bills if not managed correctly.
The takeaway
Factors are the building blocks of returns, and understanding them is the first step toward investing with purpose instead of guesswork.
When we at Motley Fool Asset Management launched our own factor-based ETFs, we didn’t set out to build the thousandth version of the same minimum volatility ETF.
We asked:
- What would factor investing look like if it started from great stocks instead of the entire market?
- What if the factor signals were built for intangible-heavy, subscription-driven, AI-era businesses — not the industrial companies of the 1960s?
The result has been a factor investing approach that stays true to the academic rigor behind the original research while modernizing the signals for the world as it actually exists today.
Explore our lineup of funds to see how we put factors to work.
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