Think of factors as the ingredients behind a portfolio's returns. When you combine those individual ingredients — like value, momentum, quality, size, and low volatility — you get what investors call multifactor investing.
For most investors, this has become synonymous with the Fama-French three-factor model1, the seminal framework for combining factors in a single portfolio. But it’s not the only way to build a multifactor portfolio. There are plenty of other approaches, each designed to serve a different purpose, whether that's to pursue higher returns or manage risk.
What Is Factor Investing?
Factor investing is a strategy that selects stocks based on measurable — often well-documented and well-researched — characteristics that drive returns. Investors often orient their portfolios toward these traits to improve outcomes, minimize volatility, and enhance diversification.
The Main Types of Factors
Most investors work with a handful of well-researched factors:
- Value: Stocks trading at a discount relative to fundamentals like earnings or book value.
- Momentum: Stocks that have shown strong recent performance are believed to keep trending upward.
- Size: Smaller companies have historically outpaced larger ones over long periods.
- Quality: Firms with robust balance sheets, stable earnings, low debt, and healthy profitability.
- Low volatility: Stocks that exhibit smaller price swings compared to the broader market.
Each factor behaves differently across market cycles. That's precisely why combining them can be so powerful.
What Does Multifactor Investing Mean?
At its core, a multifactor investment strategy builds on the long-standing concept of diversification. The logic is straightforward: factors often don’t move in lockstep, so by combining two or more in a portfolio, you stay diversified. For example, value can lag for years, like it has of late, while momentum shines. That way, when one factor underperforms, another may outperform as a counterbalance.
How to Build a Multifactor Strategy
Two roads lead to building a multifactor portfolio, and neither is wrong.
Combine Individual Factor ETFs
You can build a multifactor portfolio using single-factor ETFs, several of which Motley Fool Asset Management offers. Buy a value ETF, a momentum ETF, and a quality ETF, then weigh them according to preference.
The upside is control. You decide the exact mix and rebalance on your own terms. The downside is that this type of strategy demands ongoing attention, and the factors could occasionally cancel each other out.
Invest in a Single Multifactor Fund
Alternatively, you can buy a single multifactor ETF that includes everything in one package. The fund manager handles all the blending, rebalancing, and factor selection.
This is the low-maintenance option. It offers investors diversified factor exposure without juggling five tickers. For many investors, the simplicity is worth it.
Approaches to Combining Factors
Here's where the options get interesting. How you combine factors matters just as much as which ones you choose.
Top-Down vs. Bottom-Up
A top-down approach builds separate sleeves for each factor, then stitches them together.
A bottom-up approach evaluates every stock across all factors at once, then selects the names that score well overall.
Mixed vs. Integrated
The mixed method is the top-down version in practice: the investor owns distinct factor portfolios and combines their returns. It's transparent and easy to explain.
The integrated method scores each stock on multiple factors simultaneously and buys the best all-around names. This is often more efficient because it avoids a common trap.
Here's a pitfall investors should watch for in a mixed portfolio: the value sleeve might buy a stock the momentum sleeve is selling. The two cancel each other out, and the investor pays trading costs for the privilege. Integrated approaches sidestep that tug-of-war.
Static vs. Dynamic
A static strategy keeps factor weights fixed. Value remains at 25%, momentum at 25%, and so on, no matter what happens.
A dynamic strategy shifts weights based on market conditions or valuations, leaning into factors that look attractive and trimming those that look stretched. This strategy offers flexibility but demands skill and discipline to execute well.
Neither is inherently superior. Static is simpler and cheaper, but a dynamic strategy can add value if the timing calls are right.
The Classic Factor Models
Several established models show just how varied the options can be:
- Fama-French 3-factor: Market, size, and value.
- Fama-French 5-factor: Adds profitability and investment to the original three.
- Carhart 4-factor2: Fama-French three plus momentum, a favorite for capturing trends.
- AQR-style3: Value, momentum, quality (quality-minus-junk), and low-beta (betting-against-beta). A well-rounded specialty pie.
- Barra-style4: Dozens of style and industry factors combined through regression.
Factor Combinations to Know
Some pairings have earned their reputation:
- Momentum + value: A classic hedge. Value buys the cheap and unloved; momentum rides the winners. When one stalls, the other may often outperform.
- Value + growth: A balance between bargain hunting and betting on expansion, softening the swings between value and growth cycles.
- Quality + low volatility: A defensive combination for investors who prize stability over fireworks.
The right combination depends on the investor’s goals, time horizon, and how much volatility they are willing to tolerate.
The Takeaway
Multifactor investing isn't about finding one perfect formula. It's about understanding the elements well enough to build a strategy that is appropriate for each investor. The three-factor model may be a fine choice, but it's not the only option worth considering.
Whether you prefer to blend individual factor ETFs yourself or let a single multifactor fund do the work, the goal is the same: capture the benefits of proven return drivers while keeping the ride manageable.
Curious about putting factors to work in your portfolio? Check out our lineup of factor ETFs at Motley Fool Asset Management.
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