There’s a reason factor investing hasn’t faded with other investment strategies of yesteryear. Momentum, value, and other factors have each built a track record in different market cycles. When put together in a multifactor strategy, the whole has historically been greater than the sum of its parts.1 So how does a multifactor approach actually work? Let’s take a closer look.
First, we need to revisit factor investing
Factor investing was popularized in the early ’90s when two future Nobel Prize winners, 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 help explain returns beyond market risk alone. It would take another decade for BlackRock, Dimensional Fund Advisors, and other asset managers to turn this academic research into widely available investment products.
But like most things, once too many hands get on something, it all starts to look the same—and that’s exactly what happened with factor investing. While corporate America has radically changed, where hard-to-quantify intangible assets like brand equity and social media are now paramount, many investors are still running factor strategies built on the same old financial ratios and market metrics.
So that got us at Motley Fool Asset Management thinking: How could we put our Foolish spin on factor ETFs in a way that modernizes smart beta strategies and uncovers alpha opportunities, all while staying true to our distinctive investing philosophy? Our solution was simple: combine the ethos of Foolish Investing with best-in-class factor research. Start with great stocks hand-picked by The Motley Fool, LLC’s analysts, apply a modern twist to scoring factors, maintain a long-term fundamental focus, and aim to maximize information ratios.
Put it all together, and you get Motley Fool Asset Management’s lineup of factor ETFs.
What is a multifactor investment strategy?
Now, when you combine these individual factors in a portfolio, you get a multifactor strategy built on one of the oldest investing lessons: diversification, the idea that spreading your money across assets of different sizes, from different regions, or with different themes can help minimize market volatility and deliver consistent returns.
The same concept applies to factor investing. One factor can lead to a hot winning streak, but over time, that same narrow focus exposes investors to losses, and before you know it, headlines start reading, “Value Investing Is Dead” or “Can Momentum Investing Be Saved?”
So by blending multiple factors within a portfolio, investors can potentially avoid the highly cyclical nature of factor returns.2
For example, during the early stages of economic expansion, factors such as value and size may outperform based on accelerating growth. Conversely, during slowdowns, defensive factors such as quality and low volatility can take center stage. Such cyclical behavior is driven by shifts in market sentiment, policy changes, and the economy. Investors who bet on a single factor need perfect timing, something which no one has.
But together, each factor can help act as a counterweight. While value stocks might struggle during a rapid growth phase, momentum stocks could pick up the slack. And then when momentum falters during a market correction, high-quality or low-volatility holdings could help provide a stabilizing anchor. Together, mixing factors can create a smoother ride, helping investors stay invested through turbulent markets without necessarily sacrificing earnings potential.
Combining the ingredients into a multifactor strategy
Let’s consider how mixing factors may impact a portfolio.
Value and momentum: A classic pairing
Value investing is famous for its discipline, but it carries a distinct risk. A company might have a low valuation simply because it’s poorly managed, in financial distress, or in a declining industry. Not every inexpensive stock is a bargain.
Conversely, momentum investing chases winners. The risk here is that an investor might be sitting at the top before the bottom falls out.
Combining value and momentum can help manage these risks. You can screen for stocks that are undervalued by the market but have recently started to trend upward. The momentum factor can steer you are away from buying a dying business, while the value factor can help protect that you aren't overpaying for hype. It is a powerful way to invest in value while learning how to identify potential momentum winners.
Value and “growth at risk”: A pairing about upside
One way to think about this pairing is investing at both ends of a spectrum. At one end sit value stocks, which are often beaten-down names for reasons other than mismanagement or malfeasance. In other words, value stocks show potential for promise or bouncebackability.
Combine that with “growth at risk,” which sits at the other end from traditional value stocks. These are names with high brand value, strong R&D, or immeasurable processing power. You know, that IT factor you hear about in sports, but applied to investing. It’s too squishy or risky to have a line item on a 10-K, but because they’re hard to measure, the market often misprices them, which is why they can earn higher returns.
So together, value and “growth at risk” play on the idea of delivering higher return potential, but like anything in the market, high rewards require high risk tolerance.
Risks and benefits of the multifactor approach
Like any strategy, multifactor investing has its own set of trade-offs.
Benefits of a multifactor strategy
Smoother returns: By relying on multiple drivers of return, it’s possible to help reduce the extreme highs and lows associated with single-factor portfolios.
Reduced uncompensated risk: By combining factors, you’re not putting all your eggs in one basket—so you’re less likely to take on risk that wouldn’t get rewarded.
Adaptability: A diverse factor mix should naturally adjust to different economic cycles, whether the market favors growth, value, or defensive posturing.
Risks of a multifactory strategy
Underperformance in extreme market conditions: During periods when a single style or theme skyrockets, think tech in the run-up to the 2000s, a diversified multifactor portfolio will likely underperform such a narrow benchmark.
Complexity: Building these portfolios requires sophisticated screening and rebalancing. If the underlying methodology is flawed, the factors could cancel each other out, leaving you with average returns but higher fees.
Patience is Required: The benefits of factor investing materialize over years and decades, not weeks or months.
The takeaway
It’s impossible to predict which specific style of investing will succeed this year, next year, or the one after that. But by embracing a multifactor strategy, you don’t need to. Because all the factors in your portfolio work together to cover each other’s blind spots, helping create the potential for a more consistent path for returns over time.
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