The Factor Effect: A Brief History of Capturing Alpha While Curbing Impulses

“The investor’s chief problem – and even his worst enemy – is likely to be himself.”
- Benjamin Graham, The Intelligent Investor

Factor investing is gaining wider appreciation. Academic papers have demonstrated that Factors are the leading determinant of the elusive concept we refer to as Alpha.¹ Like active management Alpha, Factors are also cyclical, but unlike active management they maintain their objectivity throughout a market cycle, without some of the drift or subjectivities which may arise in active management. For investment counsellors looking for complementary strategies or to invest in International or Global equity markets, Factor equity ETFs may provide suitable exposures to help diversify portfolios and manage risk.

Investors are drawn to active management because it provides several appealing refinements to indexing investing; principally a concentrated, high-conviction portfolio with high active share and lots of tracking error, providing the ability to produce Alpha or outperformance.

Interestingly, in our view Factors offer the same attributes, albeit in a transparent, rules-based methodology which, in most cases, is more enduring than active manager cyclicality.

Alpha / Beta Definition and the Rise of Modern Investing

The S&P 500 index was conceived in 1956 and published the following year. It was intended to be a measuring tool to determine whether active managers were skillful or lucky. Though the Dow Jones Industrial Average had been a benchmark since the late nineteenth century, the price-weighted index had outlived its relevance. Heightened computing power was able to track more companies, providing a more representative market capitalization perspective.

The outcomes were surprising. Most active managers were unable to provide consistent outperformance over the benchmark, sparking interest in synthetic exposures including futures and swaps. 

Around the same time and into later decades, academics proposed several concepts to explain investment performance, ranging from Harry Markowitz’s Modern Portfolio Theory (MPT) in 1952 to the Capital Asset Pricing Model, or CAPM (1964), to the Efficient Market Hypothesis (EMH) in 1970. These theories sought to explain capital market behaviour. 

Notwithstanding the strong foundation these approaches provided, researchers continued to tabulate returns, parsing them through increasingly detailed attribution analyses, eventually identifying clearly defined investment Factors that explained returns. Using copious data, a view emerged that Factors explained the variability across different active managers, more so than security selection or market timing.

Factors differ markedly from investment styles, demonstrating significant enhancements over simple Growth and Value distinctions. Whereas Style indices retain a market capitalization weight, Factor indices weight constituents by their Factor matrices, producing a more concentrated, higher-conviction portfolio, similar to what might be expected in an active mandate.

Source: BMO Global Asset Management. For illustrative purposes only. 

Identifying Factors was a significant leap ahead of the elementary distinction that Alpha/​Beta had provided in the 1950s, but Factors also helped explain what psychologists called ​“behavioural finance” — or the emotional impulses that defied the data-driven, logical directives established in MPT, CAPM and EMH. 

In investing, as in life, there is a constant struggle between logic and emotion, perhaps best summarized in a simple quote from Benjamin Graham’s book The Intelligent Investor: ​“The investor’s chief problem – and even his worst enemy – is likely to be himself.”

Such humble comments acknowledge that some elements in investing may not always be grounded in data-and process-driven. Even professional allocators should be aware some of their own decisions may be infused with preferences or biases.

Factors, due to clearly defined characteristics, provide objectivity and consistency in their data sets, establishing a strong engagement platform for investment counselling firms with their clients.

It is useful to appreciate how Factors capture innate financial behaviours but it is also important to appreciate the strong investment thesis they provide to asset allocation and portfolio construction. As the table below outlines, most Factors have historically displayed both enhanced performance and lower risk on a compounded basis. The sole exception is Value which, in part, can be explained by the stimulative or accommodative rates we have had for may years. When rates rose in 2022, Value showed its worth.

Table 1 – Diversification Effects Over Longer Time Periods

Longer time horizons > higher historical occurrence of outperformance, with diversification benefits becoming apparent over longer investment periods.

Understanding Factors, their essence, strong investment thesis and how they can be aligned provides multi-family offices and investment counsellors with a better ability to shape portfolios to meet client risk and return objectives. 

As one of the strongest Factor ETF providers in Canada, BMO ETFs offers listings for Low Volatility, Dividend, Quality, Size and Enhanced Value across Canada, the United States, International and Global mandates.

Please contact your BMO institutional sales partner for additional market insights.

Performance (%):

Source: Bloomberg, as of February 28, 2025. Inception date for ZLB = October 21, 2011, ZLH = February 4, 2016, ZLU = March 19, 2013, ZLU.U = March 19, 2013, ZIQ = October 24, 2024, ZUQ.F = July 17, 2020, ZUQ = November 5, 2014, ZUQ.U = July 20, 2020, ZDV = October 21, 2011, ZVC = October 4, 2017, ZLD = February 4, 2016, ZLI = September 2, 2015, ZGQ = November 5, 2014, ZUD = March 19, 2013, ZDY = March 19, 2013, ZDY.U = March 19, 2013, ZVU = October 4, 2017, ZLE = May 10, 2016, ZEQ = February 10, 2014, ZMID = February 5, 2020, ZMID.F = February 5, 2020, ZMID.U = February 5, 2020, ZSML = February 5, 2020, ZSML.F = February 5, 2020, ZSML.U = February 5, 2020.

¹ ​“Factor investing: alpha concentration versus diversification,” L. Heinrich, A. Shivarova, M. Zurek. Journal of Asset Management, 2021.