Factor premiums are a way to capture extra returns by focusing on specific stock characteristics like value (cheap stocks), size (smaller stocks), and momentum (stocks on the rise). These factors have consistently provided investors with returns above the market average, even over long periods.

A key takeaway is that factor premiums aren’t just a passing trend. Recent research spanning more than 150 years shows they are a stable and lasting feature of financial markets. So, for long-term investors, factor investing offers a solid way to enhance returns.

What Are Factor Premiums?

At their core, factor premiums are returns generated by investing in stocks that share certain characteristics. Factors like value (buying cheap stocks relative to earnings or assets), momentum (investing in stocks that have been rising), and size (favouring smaller companies over larger companies) have historically outperformed the broader market.

These characteristics can be seen as “risk premiums” because they come with certain risks that investors are compensated for, like the risk that cheap stocks may remain cheap for some time or that high-momentum stocks could fall just as quickly.

Why Should You Care?

You may be wondering why factor premiums matter to your portfolio. By focusing on factors, investors can potentially capture higher returns than simply holding the entire market. It’s a strategy that many financial professionals use to tilt portfolios toward better-performing parts of the market.

For example, you might invest in a value-oriented mutual fund or ETF that seeks out stocks with low price-to-earnings ratios. Over the long term, these kinds of investments have been shown to deliver extra returns.

Stability Through Time

The big question is: are factor premiums reliable over time? Recent research shows that factor premiums have persisted for over a century. This means that investors can confidently build portfolios that target these factors, knowing that they are not just anomalies from short-term data or market cycles.

The Practical Side

If you’re thinking about incorporating factor investing into your strategy, the easiest way is through factor-based ETFs or mutual funds. These funds are managed to target specific factors like value or size, providing a simple way to tap into the potential for extra returns.

Bottom Line

For long-term investors, understanding and utilizing factor premiums could be a key to enhancing returns. These factors have been shown to be stable over the years, making them a reliable strategy in a well-diversified portfolio.

Factor investing isn’t a get-rich-quick strategy, but it can be a powerful tool for patient, disciplined investors looking for an edge.