Factor Investing: Looking Beneath the Market

An equity factor is a measurable characteristic that can be used to group, compare, or weight companies. Examples include valuation, earnings growth, profitability, price momentum, market capitalization, trading liquidity, dividend yield, and price volatility. Factor strategies systematically emphasize one or more of these characteristics.

Investors have traditionally viewed the stock market through a few familiar lenses. Stocks are often grouped by geography (or country of domicile), the sectors and industries in which they operate, or their size. Factor groupings offer a way to look at the market based on the underlying characteristics that stocks share, rather than where they fit within a traditional index.

Factor-based investing has been around for a long time, with roots in valuation-oriented methodologies. Common factor characteristics include valuation, growth, price momentum, profitability, balance-sheet strength, size, and volatility. Organizing stocks this way can give investors a more targeted view of the underlying drivers of risk and return. It can also complement traditional stock analysis by helping investors understand not just what they own, but some of the characteristics they are exposed to by owning it. Factor-based portfolios deliberately depart from market-cap weights, with the resulting exposure depending on how the factor is defined and constructed.

Consider two companies in completely different industries. A technology company and a health care company may have little in common from a sector perspective, but both could have strong earnings growth and rising share prices. Likewise, a bank and an industrial company could both trade at relatively inexpensive valuations. A sector lens separates those companies. A factor lens groups them by their shared characteristics.

Factor analysis can help explain what's happening beneath the surface of an index or sector. A market advance that appears broad, for example, may be disproportionately rewarding companies with strong momentum or growth characteristics. Similarly, a portfolio diversified across many sectors may have large relative exposure to valuation, size, or profitability-based factors. Measuring those exposures can help investors better understand their portfolio exposures and performance. Historically, active portfolio managers have often used factor analysis for precisely this kind of risk management and performance attribution.

Factor analysis doesn't replace traditional equity analysis. It's another lens that can help investors see what may be driving returns beneath the index or sector level and identify exposures that traditional classifications may not reveal.

A factor's name doesn't tell investors everything they need to know. Definitions, stock selection, weighting, rebalancing, starting universe, and sector exposure can cause two investment strategies bearing the same label to have very different underlying characteristics and produce different returns.

Schwab's U.S. equity factor framework begins with the S&P 500 and ranks each company within its respective sectors on various characteristics. We then aggregate the highest-ranked quintile (top 20%) across all sectors. This sector-neutral process is intended to isolate the selected characteristic, rather than reproduce an unintended sector allocation.

Comparing stocks with others in the same sector can help separate the effect of a characteristic from the performance of the sector itself. This matters because accounting measures and valuations can differ substantially across industries. Without adjusting for these differences, what looks like a Value or Quality signal may have a large sector tilt. Ranking companies against sector peers reduces that distortion, but it doesn't eliminate all sector effects.

The Growth factor favors companies with strong sales and earnings trends. This factor has tended to perform well during periods of economic expansion and/or when there are wide growth differentials across equities. As we've seen in recent years, sustained strong earnings growth from certain stocks or industries can lead to persistent Growth outperformance.

Interest rates are relatively important for growth-oriented stocks because a larger share of a company's estimated value may depend on earnings expectations that are further in the future. The trade-off is embedded expectations: strong anticipated growth might already be reflected in the stock price, leaving less room for disappointment.

Liquidity measures how easily a stock can be bought or sold. Stocks with higher liquidity generally have larger trading volume and lower bid/ask spreads (the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to accept). Liquidity may become particularly important when uncertainty rises and investors value the ability to adjust positions. However, in periods of acute volatility, more liquid stocks can be sold more easily than stocks with poor liquidity, even if they are higher quality. Because larger companies tend to trade more actively, Liquidity and Size factor portfolios can have relatively high degrees of overlap, meaning the same stock can be in both factor buckets.

Volatility groups stocks with high historic price and/or earnings volatility and higher sensitivity to broad market movements. It's most common that investors choose to add Low Volatility strategies (Low Vol) rather than High Volatility (High Vol) ones. Low Vol stocks may offer defensive characteristics and have often declined less during broad market weakness, as the chart below shows, but they may lag when more speculative or economically sensitive stocks rally.

Momentum favors stocks with strong recent price performance. It reflects the tendency of market trends to persist as investors gradually respond to new information and chase recent winners. Momentum can be powerful while leadership remains stable. It can also reverse abruptly, particularly near market turning points or after crowded trades unwind. Relatively rapid changes in leadership can create a whipsawing effect, whereby market leadership changes rapidly, and potentially lead to Momentum underperformance. These changes have led to bouts of general market volatility over the past 25 years. The chart below shows the relative performance of the MSCI USA Momentum Index against the S&P 500 Equal Weight Index and the CBOE Volatility Index (VIX), which measures volatility implied by the options market.

Quality emphasizes profitable, financially strong, and relatively stable companies. Common measures include profitability, leverage, and earnings consistency. These characteristics may become more valuable when economic risk increases. Financial strength, however, doesn't determine whether a stock is attractively priced. The chart below plots the return on equity (ROE) of Quality against other common factors and shows its higher profitability. It also shows how the Value factor has the lower profitability. Weak profitability can partly explain low valuation.

Schwab's Size factor is based on market capitalization. Currently, the median market cap of the largest quintile, or top 20%, is almost 14 times larger than the median market cap of the smallest quintile, or bottom 20%, as shown in the chart below. Our research shows large companies typically have broader access to financing, more analyst coverage, and more diversified operations. Smaller companies may lead when economic growth broadens and credit is readily available. Larger companies may hold an advantage when financing conditions tighten or investors place a premium on earnings visibility.

The Value factor seeks stocks trading at low prices relative to fundamentals like earnings, cash flow, or sales. Low stock valuations can create opportunity when expectations are too pessimistic, pushing the prices investors are willing to pay downward. But low valuations can also reflect real financial deterioration, and in such cases, a low valuation could be warranted.

Detailed analysis of a company's financial health and growth outlook may help distinguish between those stocks that are mispriced by the market and those whose valuations reflect deteriorating company fundamentals (often referred to as a "value trap"). Using several valuation measures and comparing companies with sector peers may reduce the risk of buying a value trap, but it cannot eliminate it.

Yield favors companies with relatively high dividend yields. It can appeal to investors seeking higher current income or businesses with mature, but stable, cash-flow profiles. A high dividend yield is not automatically attractive. It may result from a falling stock price and could indicate that the market is pricing in financial deterioration. Growth prospects, balance-sheet strength, free cash flow generation, and dividend payout sustainability remain important.

The return "quilt" shown below ranks factors by performance each year and illustrates the point that factor leadership changes quite often.

The outperformance of Growth and Momentum reflects, in part, the strong, sustained earnings growth and performance of large-cap Tech and Communication Services companies that have taken market share and delivered strong profitability over the last decade. In our view, the more recent performance of Value and Yield suggests to us the market is shifting its focus to potentially less-crowded parts of the market.

While performance trends and changes can reveal what the market has rewarded and how it might be changing, it doesn't establish what will lead next.

There are many ways to measure the business cycle, each of which has its own strengths and weaknesses. However, it's helpful to understand how markets have historically behaved under various conditions. Factor performance trends have displayed some relatively intuitive patterns.

Our analysis shows, more risk-seeking characteristics, like volatility, small cap, and value, have tended to outperform in early-cycle or recovery periods. More defensive characteristics, like stable earnings, low price volatility, and high dividend yield, have historically outperformed during economic slowdowns and recessions.

The chart below uses the level and change of the Organisation for Economic Co-operation and Development's (OECD's) U.S. Composite Leading Indicator (CLI) as a proxy for a business cycle indicator. We have listed three factors in each phase of the cycle that have tended to perform well in our analysis.

Just as we considered factor performance in business cycle phases, we can also consider them against macroeconomic regimes based on growth and inflation dynamics. In the chart below we plot the last five years of our U.S. Growth and Inflation Indicator, a proprietary indicator that tracks the level and rate of change of economic growth and inflation data, and list the three factors that have tended to perform best in each phase.

This too is an imprecise exercise, and all cycles and regimes have their own idiosyncratic drivers. Based on our measure's latest reading, we're in a relatively subdued high-growth and high-inflation phase. Historically, equity market total returns have been positive in this phase, but the trade-off between strong growth and inflation risk has delivered mixed factor results in our analysis. Stocks with high liquidity, or those with favorable quality, have historically performed well during these periods.

Economic regimes can help investors understand why leadership is changing. However, they are less reliable as precise trading signals.

A Goldilocks environment characterized by strong growth and low inflation can be supportive for equities as inflation and interest rate risk tend to be relatively low. This can also support stocks with high dividend yields as bond yields tend to be relatively low.

Stagflationary environments—where high inflation drives interest rates up, but growth remains weak—are historically the most challenging environment for equities. Investors may place greater value on defensive factors like Quality and Low Volatility, while Value can work in an environment where valuation multiples compress.

These relationships are tendencies, not rules. Valuation, market positioning, interest rates, credit conditions, economic changes, and other variables can alter the outcomes.

Using economic regimes to time factor allocations requires investors to make two difficult judgments correctly: (1) identify the regime; and (2) determine how much of it the market has already priced in. By the time an economic label becomes obvious, markets may have already priced in the different environment.

The business cycle can still provide a useful framework. Early recoveries may reward stocks with high liquidity and greater economic sensitivity. Mature expansions can favor profitable cyclical companies. When growth slows, investors may pay more for dependable earnings and financial strength.

Inflation, valuations, credit conditions, and market positioning can disrupt these patterns. A factor playbook works best to frame questions about the current market environment to help consider whether adding factor exposures can better align a portfolio with objectives.

Factors can serve three practical purposes.

1. Factors can help explain market leadership. If Growth and Momentum lead together, the market may be rewarding persistent earnings trends and price strength. If Quality and Low Volatility lead, the market may be placing greater value on stability and financial resilience.
2. Factors can expose hidden portfolio concentrations. A collection of stocks from different sectors may appear diversified while sharing similar Growth, Size, Quality, or Momentum characteristics.
3. Factors can help investors compare securities and investment strategies more consistently.

Factors can help explain what's driving market leadership, identify characteristics shared across seemingly different holdings, and improve the evaluation of investment strategies. Economic regimes may help explain why factor leadership changes, but they should not be treated as precise forecasts.

The practical value of factor investing is not the promise of finding a permanent winner, it's a clearer understanding of what an investor owns, which risks are concentrated in the portfolio, and how those exposures could behave as financial conditions change.

Momentum can suffer during abrupt reversals. Value can underperform for years. Low Volatility can lag during powerful market advances. Strategies focused on smaller companies can face liquidity, financing, and trading-cost challenges.

These cycles help explain why a diversified factor approach may be more durable than dependence on a single characteristic. Different factors respond to different economic and market forces, so their strongest and weakest periods do not always coincide.

Before pursuing factor strategies, investors should examine the underlying details, including definition, the universe of underlying stocks, sector exposures, weighting methodologies, rebalancing processes, costs, and correlation to holdings. Investors should also consider whether they can remain invested through a prolonged period of underperformance.

Michael Rawson, Analyst, Equity Research and Strategy, contributed to this report.