Cut Through the Noise! These Two Factors Tend to Drive Portfolio Success

Let’s break down how to build a robust factor portfolio—without getting lost in the weeds. Three steps. No fluff. Here’s what we’re covering:

1. Why factor investing even matters
   
2. Which factors have historically delivered
   
3. What it actually takes to live with a factor portfolio

And yeah, we’ll get nerdy. That’s just what we do.

If you want to watch the video version of this blog, make sure to follow us on our YouTube channel:

First, Why Even Bother with Factors?

Simple: because factors represent independent sources of risk and return—which means real diversification potential. Going back to modern portfolio theory 101, investors should target assets that:

1. Have positive expected returns
2. Are imperfectly uncorrelated to one another

Historically, factors have delivered both. And because you can layer them on top of existing asset class exposures—most notably, equities—they’ve historically added distinct return streams beyond what the broad market provides.

Even a modest edge—say, a 1% annual bump—can do major damage (in a good way) over time. That’s compounding at work.

To keep things focused, let’s zero in on four main factors and see which have historically offered both return and diversification benefits:

• Value: Stocks trading at a discount relative to fundamentals
  
• Momentum: Stocks with strong performance over the past year
  
• Size: Smaller-cap stocks
  
• Profitability: Firms with strong operating margins
  

So What Works? (and What’s Overhyped?)

We pulled the data from the Kenneth French data library to run a simple horse race to see which factors have done the heavy lifting.

First up: The long/short version

This approach buys the top-ranked stocks and shorts the bottom-ranked ones—essentially isolating the factor premium. Here’s how these factors stack up:

• Momentum and the market come out on top
  
• Then profitability, value, and size trail in that order
  

At first glance, it’s tempting to say, “Great—momentum wins, let’s bet the farm!” But hold up!

Long/short portfolios might look great on paper, but they’re tough to run in real life. Besides, most investors don’t actually allocate by shorting the ‘other side’ of the bet. And in the wrong market environment, these strategies can absolutely blow up.

So let’s pivot to something more realistic: long-only portfolios. No shorting. Just buying the top-decile stocks.

Now things get interesting.

• Value jumps ahead of profitability
  
• Momentum still comes out on top
  
• Profitability holds up well
  
• Size lags the market
  

Here’s what $1 turned into (from 1963–today):

• Small-cap stocks: $818.70
  
• Profitable stocks: $2,134.71
  
• Value stocks: $4,664.68
  
• Momentum stocks: $31,697.62
  

Sure—these are paper portfolios, gross of fees. But still. That’s pretty impressive. So if your only goal is maximizing return, value and momentum look like no-brainer candidates. But here’s the catch: They can go through long, painful droughts (hello, 2015–2020), and if you’re not mentally prepared, you’ll likely bail at the worst possible moment.

Conviction matters. And let’s be clear: conviction cannot be borrowed.

Building a Portfolio That Doesn’t Break You

Let’s now move from theory to practice.

First off, if you’re an index investor looking for some factor exposure without completely blowing up your tracking error, diversification is the name of the game. To that end, let’s check the correlations between long-only factor portfolios:

• Value and momentum are the least correlated with the market
  
• Even better: value and momentum are also lowly correlated with each other. In fact, in this whole table, value and momentum are the most uncorrelated of the bunch.

Translation: They’re not just the strongest return generators in this data set—they also appear to offer the most diversification benefits. When it comes to fulfilling our portfolio construction mandates, value and momentum seem to stand head and shoulders above the rest.

Alright, let’s say you’re sold. You want in. So how much of your equity sleeve should go into concentrated factor exposures?

There’s no magic number, but allocating 20–50% to concentrated factor exposures seems like a solid starting point for an equity sleeve. Less than 20% might not move the needle, while more than 50% could lead to wild tracking error (and some judgmental glances from your friends who index-and-chill).

The key is knowing your own behavioral limits.

In general, the more you can stomach looking different from the market, the more room you have to lean in. But if tracking error keeps you up at night, it’s better to ease off.

At the end of the day, it’s not just about what you believe—it’s about what you can stick with.