Factor investing is a systematic way to target higher returns by tilting your portfolio towards stocks with specific characteristics that have historically outperformed. It sits between passive index investing and fully active stock picking. Here is how UK investors can use factors to potentially boost long-term returns.
What Is Factor Investing?
Factor investing means deliberately overweighting stocks that share certain measurable traits β called factors β which research has shown tend to deliver higher returns over long periods. Instead of buying every stock in an index equally, you tilt towards the stocks that score well on one or more of these factors.
The idea is rooted in decades of academic research, starting with the Capital Asset Pricing Model in the 1960s and expanding through Fama-Frenchβs three-factor model in the 1990s. The core finding: certain types of stocks consistently earn higher returns than others, and these differences cannot be fully explained by chance or simple market risk.
Factor investing is sometimes called smart beta because it uses rules-based methods to construct portfolios that differ from traditional market-cap-weighted indices.
The Main Factors
There are five widely recognised equity factors, each capturing a different source of higher returns:
1. Value β Buying Cheap Stocks
Value stocks are companies that appear cheap relative to their fundamentals β low price-to-earnings (P/E) ratio, low price-to-book (P/B) ratio, or high dividend yield. The idea is simple: buy pounds worth of assets for less than a pound, and wait for the market to recognise the bargain.
Value has one of the longest track records in finance. Research by Fama and French covering data from 1926 onwards found that value stocks outperformed growth stocks by roughly 3-5% per year in the US. In the UK, the FTSE All-Share Value index has shown a similar pattern over multi-decade periods.
Value investing works because it exploits behavioural biases β investors tend to overpay for exciting growth stories and underpriced boring companies. When those boring companies recover, the value investor profits.
UK value ETF:
- iShares MSCI UK Value Factor (IUVF) β OCF 0.55%. Tracks the MSCI UK Enhanced Value Index, which selects UK stocks with the strongest value characteristics.
2. Momentum β Riding Winners
Momentum stocks are those with strong recent performance β typically over the past 6-12 months. The theory is that trends tend to persist: stocks that have been going up are more likely to keep going up, at least over the medium term.
Momentum is one of the most powerful factors historically, but it is also one of the most volatile. Momentum strategies can suffer sharp drawdowns when trends reverse suddenly (known as momentum crashes). Research by Jegadeesh and Titman found momentum delivered roughly 1% per month in US data from 1965-1998.
Momentum works because of investor underreaction to new information β good news takes time to fully filter into stock prices.
UK momentum ETF:
- iShares MSCI UK Momentum (IUKM) β OCF 0.55%. Tracks the MSCI UK Momentum Index, selecting stocks with the strongest price trends.
3. Quality β Buying Great Businesses
Quality stocks are companies with high profitability, stable earnings, low debt, and strong competitive positions. These are the businesses you would happily own forever β consistent cash generators with pricing power.
Quality investing has gained popularity since Asness, Frazzini and Pedersen published their research in 2019 showing that quality stocks outperformed the market with lower volatility. The key insight: investors systematically underpriced safe, profitable companies and overpriced risky, unprofitable ones.
In the UK, quality stocks have tended to include companies like Unilever, AstraZeneca, and Diageo β businesses with global brands and recurring revenue.
UK quality ETF:
- iShares MSCI UK Quality (IUKQ) β OCF 0.55%. Tracks the MSCI UK Quality Index, selecting companies with high return on equity, stable earnings growth, and low financial leverage.
4. Low Volatility β The Defensive Anomaly
Low volatility stocks are those with below-average price fluctuations. Counterintuitively, research going back to the 1970s has shown that these calmer stocks have delivered similar or higher returns to the overall market β meaning better risk-adjusted returns.
This anomaly contradicts the fundamental principle that higher risk should mean higher returns. Explanations include lotteryεε₯½ (investors overpaying for exciting, volatile stocks), institutional constraints, and borrowing limits that prevent investors from levering up safer stocks.
UK low volatility ETF:
- iShares MSCI UK Minimum Volatility (IUKV) β OCF 0.55%. Tracks the MSCI UK Minimum Volatility Index, which constructs a portfolio of UK stocks designed to have the lowest possible overall volatility.
5. Size β The Small-Cap Premium
Size refers to the historical tendency of smaller companies to outperform larger ones. The small-cap premium has been documented extensively β Fama and French found US small-caps outperformed large-caps by roughly 2-3% per year from 1926-2006.
In the UK, smaller companies on the AIM market or FTSE SmallCap index have shown similar patterns. However, the small-cap premium has been weaker in recent decades, and smaller companies carry higher costs, lower liquidity, and greater business risk.
UK size ETFs are less common for factor purposes, but trackers like the iShares FTSE 250 (MIDD) provide exposure to mid-cap UK stocks with a size tilt.
Multi-Factor Investing
Rather than betting on a single factor, many investors combine multiple factors in a single portfolio. This reduces the risk of prolonged underperformance from any one factor β value can go through long droughts (as it did in the late 2010s), and momentum can crash suddenly.
Multi-factor ETFs construct portfolios that score well on several factors simultaneously, or blend multiple single-factor strategies. The academic evidence suggests that combining factors improves risk-adjusted returns because factors tend to be positively correlated in the long term but uncorrelated over shorter periods.
UK multi-factor ETF:
- iShares MSCI UK Multi-Factor (IUKMF) β OCF 0.55%. Tracks the MSCI UK Diversified Multi-Factor Index, which blends value, momentum, quality, and low volatility in a single fund.
Worked Example
Scenario: Sarah is 30 years old and earns Β£45,000 per year. She invests Β£500 per month into her stocks and shares ISA. She decides to allocate 20% of her portfolio to UK factor ETFs and 80% to a global index fund.
Her factor allocation is split equally:
- 5% iShares MSCI UK Value Factor
- 5% iShares MSCI UK Momentum
- 5% iShares MSCI UK Quality
- 5% iShares MSCI UK Minimum Volatility
Her remaining 80% goes into a low-cost global index fund like Vanguard FTSE Global All Cap (OCF 0.23%).
Assumptions:
- Global index returns 7% per year (long-term average)
- Factor allocation returns 8% per year (1% factor alpha)
- 30-year investment horizon
- Monthly contributions of Β£500
Results after 30 years:
- Without factor tilt: approximately Β£567,000
- With factor tilt: approximately Β£608,000
- Additional wealth from factor tilt: roughly Β£41,000
That Β£41,000 comes from just a 1% annual premium on 20% of the portfolio β illustrating the power of even modest factor premiums compounded over decades.
If the factor premium were 2% instead of 1%, the additional wealth would be approximately Β£85,000. Of course, past premiums do not guarantee future results.
Risks and Limitations
Factor investing is not a free lunch:
- Factor timing risk β Factors can underperform for years at a time. Value underperformed growth from 2017-2020. Momentum crashed in March 2020. Patience is essential.
- Higher costs β Factor ETFs charge more than plain index funds. A typical factor ETF costs 0.50-0.55% versus 0.10-0.23% for a basic tracker.
- Concentration risk β Factor portfolios are less diversified than broad market indices. They hold fewer stocks and can be tilted towards specific sectors.
- Capacity constraints β Factors work best in smaller, less efficient markets. As more money flows into factor strategies, the premiums may shrink.
- Overfitting β Some factors that looked strong in historical data may have been data-mined rather than reflecting genuine anomalies.
Tips for UK Factor Investors
- Do not over-allocate to a single factor. Even the best factor can have a bad decade. Spreading across multiple factors reduces this risk.
- Use multi-factor funds for balance. A single multi-factor ETF gives you exposure to several factors without needing to manage four separate holdings.
- Understand factor timing risk. If you cannot stomach five years of underperformance, factor investing is not for you.
- Keep fees low. Factor ETFs are more expensive than basic trackers, so compare OCFs and choose the cheapest option that meets your needs.
- Factor investing is long-term. Academic research covers periods of 30-90 years. Do not expect factor premiums to show up every single year.
- Consider your existing allocation. If you already own a global index fund, adding UK factor ETFs gives you a UK home bias with a factor tilt β make sure that matches your overall strategy.
- Use your ISA or pension. Factor ETFs generate capital gains and income. Holding them in a tax-sheltered account avoids unnecessary tax drag.
Summary
Factor investing offers UK investors a systematic, evidence-based approach to potentially earn higher returns than a plain market-cap-weighted index. The main factors β value, momentum, quality, and low volatility β each exploit different market inefficiencies and behavioural biases. By allocating a modest portion of your portfolio to factor ETFs, you can tilt towards higher expected returns without abandoning diversification entirely.
Start small, keep costs low, and give factor premiums time to work. Over decades, even a small edge can make a meaningful difference to your wealth.
For more information, visit MoneyHelper or the FCAβs investor guidance pages.