The main established factor premiums
Value premium: stocks trading at low multiples (P/B, P/E, EV/EBITDA) have historically outperformed growth stocks over long horizons. Risk story: value stocks are cheap because they are economically distressed — they carry higher business risk and underperform in recessions. Behavioural story: investors overpay for exciting growth and underpay for dull value stocks. Size premium: small-cap stocks have historically outperformed large-cap. Risk story: smaller companies are less liquid, harder to research, and more sensitive to credit conditions. Momentum premium: stocks that have risen over the past 6–12 months tend to continue rising (and vice versa). Behavioural story: underreaction to information and herding cause trends to persist. Quality premium: highly profitable, low-leverage companies with stable earnings outperform. Risk story: quality companies are counter-cyclical safe havens; investors should demand lower returns (the premium seems inconsistent with pure risk compensation). Low volatility premium: the most puzzling — low-volatility stocks outperform high-volatility stocks, contradicting CAPM’s risk-return tradeoff. Behavioural story: leverage-constrained investors reach for volatile stocks as a low-cost way to increase returns, bidding them up.
The crowding and decay question
If factors are widely known and trillions of dollars flow into factor-based ETFs and smart beta funds, does the factor premium erode? The evidence is mixed. The value premium largely disappeared in the US from 2007–2020 — exactly the period when it was most heavily traded. Momentum has partially decayed. However, behavioural factors may be self-renewing: new investors with the same biases keep entering markets, institutional constraints persist, and the capital required to fully arbitrage even well-known factors is limited by drawdown risk (factor strategies can underperform for years before recovering, deterring arbitrageurs). The risk-based factors — if the story is genuine — should never erode, because they represent compensation for systematic risk that investors can never diversify away.
“A factor premium is either compensation for risk you’d rather not bear, or evidence of a mispricing you can’t reliably arbitrage. Either way, collecting it requires patience and tolerance for painful drawdowns.”
What this means for you
Factor investing offers a structured, evidence-based approach to outperforming the cap-weighted market index — but it requires long investment horizons (10+ years) to reliably realise the premium, and the discipline to hold through extended underperformance. The value factor underperformed for over a decade before its partial recovery; momentum crashes sharply during market reversals. Diversifying across factors — rather than concentrating in one — reduces the risk of any single factor going through an extended bad period. Low-cost factor ETFs (offered by Dimensional Fund Advisors, Vanguard, iShares, and others) provide accessible exposure. The key question for any factor strategy is whether the premium is risk-based (in which case it should persist) or purely behavioural (in which case crowding may erode it).