Factor-Based Investing

Factor-Based Investing: A Smarter, Evidence-Based Approach to Wealth Building

Introduction

For decades, investors have sought ways to maximize returns while managing risk. While traditional stock-picking and market timing remain popular, academic research has revealed a more reliable way to enhance portfolio performance: Factor-Based Investing.

This approach, pioneered by Nobel laureate Eugene Fama and Kenneth French, has been further expanded by leading investment researchers like Larry Swedroe and implemented by Dimensional Fund Advisors (DFA).

At Sterling Edge Financial, we integrate factor-based principles to construct portfolios that align with long-term wealth-building goals. This post will break down what factor-based investing is, how it works, and why it’s a powerful strategy for investors of all experience levels.

Performance Premiums DFA 2023 - Watch Video

What is Factor-Based Investing?

Factor-based investing systematically targets characteristics ("factors") that have historically been associated with higher expected returns. These factors are rooted in decades of empirical research and provide a structured way to invest beyond traditional index funds.

Key Factors That Drive Returns

Research has identified five primary factors that explain stock returns:

Market Factor – Stocks have historically outperformed bonds over the long term.
Size Factor – Small-cap stocks tend to outperform large-cap stocks over time.
Value Factor – Stocks priced lower relative to fundamentals (value stocks) tend to outperform growth stocks.
Profitability Factor – Companies with higher profitability (strong earnings relative to assets) tend to deliver better returns.
Momentum Factor – Stocks that have performed well in the recent past tend to continue performing well in the short to medium term.

These factors, particularly Size and Value, were formalized in the Fama-French Three-Factor Model and later expanded as researchers, including Larry Swedroe, uncovered additional return drivers like Profitability and Momentum.

🔗 Read more about Fama & French’s research here:
Fama & French Papers

🔗 Explore Larry Swedroe’s insights on factor investing:
Larry Swedroe’s Research & Articles

How Does Factor-Based Investing Work?

Factor investing differs from both active stock-picking and pure passive indexing. Instead of guessing which stocks will outperform, it systematically tilts portfolios toward factors that have been shown to enhance returns over time.

Firms like Dimensional Fund Advisors (DFA) build funds that emphasize these factors, using rigorous academic research rather than speculation.

At Sterling Edge Financial, we use this framework to construct and manage diversified portfolios that aim to balance risk and return efficiently.

🔗 Learn more about DFA and their approach here:
Dimensional Fund Advisors

Why Factor-Based Investing?

1. Higher Expected Returns

By tilting toward well-researched factors, investors can potentially outperform traditional market-cap-weighted index funds over time.

2. Data-Driven and Evidence-Based

Factor-based investing is not about market predictions—it is grounded in decades of academic research showing which factors drive returns.

3. Better Diversification and Risk Management

A factor-based portfolio spreads risk more effectively than a standard index fund by diversifying across multiple performance drivers.

4. Lower Costs than Traditional Active Management

Unlike actively managed funds with high fees, factor-based funds offer a cost-efficient way to capture long-term performance premiums.

Factor-Based Investing in Action: An Example

Let’s compare two approaches:

A standard S&P 500 index fund – Provides broad market exposure but does not emphasize specific performance factors.
A factor-based portfolio – Tilts toward small-cap, value, high-profitability, and momentum stocks to capture historical return premiums.

Historically, the factor-based approach has generated higher risk-adjusted returns because it systematically leans into the forces that drive performance.

What the Research Says

Many studies confirm that factor investing is an effective, long-term strategy for building wealth. Here are some useful reads:

🔗 Morningstar on Factor Investing Success:
Factor Investing: What You Need to Know
🔗 Financial Times on Factor-Based Strategies:
Why Factor Investing Matters
🔗 Larry Swedroe’s Take on Factor Investing:
How Factor Investing Helps Long-Term Investors

Final Thoughts

Factor-based investing is not about chasing short-term trends. Instead, it’s about leveraging the science of investing to build a smarter, more resilient portfolio.

By focusing on proven factors like Size, Value, Profitability, and Momentum, investors can enhance returns while managing risk effectively.

At Sterling Edge Financial, we use factor-based strategies to help clients invest with confidence and discipline.

This content is being provided for informational purposes only and should not be construed as specific recommendations or investment advice. Always consult with your investment professional before making important investment decisions. Diversification and asset allocation strategies do not assure profit or protect against loss. Indices mentioned are unmanaged and cannot be invested into directly. Past performance is no guarantee of future results. Investing involves risk. Depending on the types of investments, there may be varying degrees of risk. Investors should be prepared to bear loss, including total loss of principal.

Securities offered through Registered Representatives of Cambridge Investment Research, Inc., a broker-dealer member FINRA/SIPC. Advisory services through Cambridge Investment Research Advisors, Inc., a Registered Investment Advisor. Cambridge and Sterling Edge Financial LLC. are not affiliated.