A factor is a variable or characteristic with which individual asset returns can be correlated. It can be broadly defined as any variable that is believed to be valuable in ranking stocks for investment and in predicting future returns or risks. A wide range of security characteristics have been used to define “factors.” Some factors (most commonly, size, value, momentum, and quality) have been shown to be positively associated with a long-term return premium and are often referred to as rewarded factors. In fact, hundreds of factors have been identified and used in portfolio construction, but a large number have not been empirically proven to offer a persistent improvement in return.

Broadly defined, a factor-based strategy aims to identify significant factors that can predict future stock returns and to construct a portfolio that tilts towards shares that are rich in such factors. Some strategies rely on a single factor, are transparent, and maintain a relatively stable exposure to that factor with regular rebalancing. Other strategies rely on a selection of factors. Yet other strategies may attempt to time the exposure to factors, recognizing that factor performance will vary over time.

For new factor ideas, analysts and managers of portfolios that use factor strategies often rely on academic research, working papers, in-house research, and external research performed by entities such as investment banks.

Equity style rotation strategies, are a subcategory of factor investing which are based on the belief that different factors—such as size, value, momentum, and quality—work well during some time periods but less well during other time periods. These strategies use an investment process that allocates to stock baskets representing each of these styles when a particular style is expected to offer a positive excess return compared to the benchmark. While style rotation as a strategy can be used in both fundamental and quantitative investment processes, it is generally found more in quantitative investing.

An important test is the “smell” test: Does a factor make intuitive sense? A factor can often pass statistical backtesting, but if it does not make common sense—if justification for the factor’s efficacy is lacking—then a manager may just be data-mining. Investors should always remember that impressive performance during backtesting does not necessarily imply that the factor will continue to add value in the future.