Factor Investing in lemans terms is rule based investing in stocks. In factor investing there are certain set of fixed transparent rules which are used to qualify stocks for investment. The rules set are attributes which are the driving forces behind stock returns.  A factor-based investment strategy involves tilting investment portfolios towards and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.

How Factor investing came into existence?

Reference: Fidelity||Overview of Factor Investing

In the late 1960s ,the first model of CAPM was introduced which can be considered as base of factor investing. In the first and basic model of factor investing it was suggested that a single factor market exposure drives the risk and return of a stock. Then was the time passed academics and practitioners discovered that there are other factors as well which drive the market risk and return. Stephen Ross introduced an extension of the CAPM called the arbitrage pricing theory (APT) in 1976, suggesting a multifactor approach may be a better model for explaining stock returns.

The Fama-French Model looked to account for additional factors such as size and value, in addition to broad market returns. Follow-up research by Carhart and Pastor-Stambaugh yielded two new factors, viz momentum and liquidity, respectively. As academic research evolved, newer factors, such as growth, quality, dividends, and volatility, were thought to have attributed to stock returns as well.

There are majorly two main categories of factors involved in this approach.

1. Economic Factors
2. Style Factors

Economic Factors

Economic factors include factors which are not directly related to the asset classes but change figures of economic factors affect the growth of the financial assets. Economic factors include the GDP, inflation, interest rates etc.

Style Factors

Style factors are more into focus in this approach which are directly related to the financial assets. The style factors are mostly the attributes that define the quality and return of the stocks. Following are the style factors size, value, momentum, quality, volatility.

1. Size

Size factor was one of the two factors introduced by Fama and French. They demonstrated that the return is more in small cap stocks as compared to large cap stocks. The risk premium for small cap stocks is more because they are on greater risk of being bankrupt and being of high volatile nature the investors deserve high risk premium. Size of stocks can be identified by the investors by simply looking at market capitalization.

2. Value

Value factor was the second factor of the two factors introduced by Fama and French. Value investing is basically investing in stocks which are of comparatively of lower valuation w.r.t their financials. The fundamental value of the stocks can be identifies using various financial ratios and financial data of the company. In 1949, Benjamin Graham urged investors to buy stocks at a discount to their intrinsic value. He argued that expensive stocks with lofty expectations leave little room for error, while cheaper stocks that can beat expectations may afford investors more upside

3. Momentum

Momentum is nothing but interpreting the future returns by examining the past price moment of the stocks. A common way to measure momentum is to classify stocks by 12-month price returns, which has proven to be an effective strategy for outperforming the broader market over time. Its not until the price moment the stocks comes under the radar of investors and analyst so this keeps the idea of momentum investing to work.

4. Quality

Quality of a stock can be defined by a number of factors like stable income, rising growth, corporate governance, decreasing debt. Quality of the stock can also be determined by conducting fundamental analysis of a company using various ratios like ROCE, Debt to equity, ROA, CPM, earning yield, dividend yield etc.

5. Volatility

It is suggested and observed that the stocks in the portfolio should be of low volatility which will have lower risk to return ratio as compared to broader markets. Considerable research has shown that low-volatility portfolios may also outperform the broader market over time. By classifying stocks in this way, investors may generate returns similar to the market over time, but with less ups and downs in their portfolio.

Even it is found that all the 5 factors have been a great exposure in creating a higher return than market portfolio, all the factors and cyclical and there is no guarantee that all the factors will work all the time. It is possible that large cap stocks out perform small cap stocks for a long period of time , momentum can be disrupted, high quality stocks can under perform , value investing can fell in  degrading economic and market conditions , low volatile stocks can under perform during a market rally. These performance swings can be unsettling to investors, causing them to sell and miss out on rebounding performance. The good news is that most factors are not highly correlated with one another—they are driven by different market anomalies and therefore tend to pay off at different times. Factor investing is for tactically minded investors who can get the right exposure at the right time and earn gains in the portfolio.