Like many, I started my journey in investing with a traditional all-world ETF, believing it offered the best combination of simplicity and performance. But as I got deeper into the world of investing, I discovered factors. Since then, my portfolio has been fully allocated to factor ETFs.
Here, I want to share some reflections on why I believe in a portfolio fully allocated to factors like momentum, value, and quality. These factors provide a different layer of diversification and offer the potential for better downside protection while maintaining competitive returns.
The evidence is presented through rolling 120-month returns and drawdown comparisons.
Factor investing
Factor investing targets specific, measurable characteristics (known as “factors”) associated with higher returns or reduced risk. These factors are persistent drivers of performance, such as value (undervalued stocks), size (smaller companies), momentum (recent outperformance), low volatility (stable stocks), and quality (strong financials).
Factor investing aims to capture premiums tied to economic risks or behavioral biases, offering a rules-based method to enhance diversification and long-term returns. You can choose factors exposure to build portfolios aligned with your specific goals.
Factor-based portfolio vs Benchmark
The portfolio examined here consists of three equally-weighted factor ETFs on momentum, value, and quality (three well-documented factors with extensive academic backing). Here a comparison between our factor portfolio (blue line) and the market benchmark (red line) from 2008 to 2025, showing rolling 10-year returns and drawdowns.
Some key observations emerge:
- Factors outperformance: the factor portfolio demonstrates persistent outperformance over the benchmark throughout most of the observed period. This is particularly notable during the recovery following the 2008-2009 financial crisis, where the factor portfolio establishes a performance gap that largely maintains through subsequent periods.
- Downside protection: during market downturns, particularly evident in the 2008-2009 financial crisis, the factor portfolio shows better downside protection. While both the portfolio and benchmark experience negative returns, the factor portfolio’s decline is less severe.
- Recovery behavior: the factor portfolio not only declines less during market stress but also recovers more robustly. This pattern suggests factor exposures may capture recovery momentum more effectively than the broader market.
Individual contributions
Here following some insights into how individual factors perform against the benchmark, offering valuable perspective on their distinct contributions.
Value
The value factor shows distinctive performance patterns across different market environments. The value factor, emphasizing undervalued securities relative to their fundamentals, shows pronounced cyclicality [1].
From a longer-term perspective, value has generated substantial returns, with data showing the MSCI World Value Index produced an annualized return exceeding 14% over a 40-year period [1]. However, value factor has experienced extended periods of underperformance, particularly during the tech-driven bull market of the late 2010s.
The value factor’s performance demonstrates the importance of long-term perspective when implementing factor strategies, as its premium has historically emerged over complete market cycles rather than consistently in shorter periods.
Quality
The quality factor exhibits good stability during market downturns. Quality investing focuses on businesses with solid financial foundations, such as steady profit growth and minimal debt levels. This approach naturally favors companies with stronger balance sheets that can weather economic turbulence more effectively.
During the 2008-2009 financial crisis, the quality factor demonstrated its defensive capabilities by declining less (and recovering faster) than the benchmark. Companies with solid financial standing and steady earnings have proven less likely to experience severe falls in stock prices during market downturns [2].
Momentum
The momentum factor exhibits its own unique performance signature. Momentum investing leverages the tendency of stocks that have performed well to continue performing well in the near term. This approach follows a “buy high and sell higher” philosophy rather than the contrarian “buy low, sell high” approach.
The chart demonstrates momentum’s strong performance during trending markets but reveals its vulnerability during sharp market reversals. Notably, momentum experienced a significant drawdown in 2009, which caused the 2000-2009 period to be challenging for this factor. However, during the 2010-2019 period, momentum generated an average premium of approximately 3.5%.
Why momentum works ? Behavioral biases (investors often overreact to recent news and trends), slow information diffusion (markets take time to fully incorporate new information), institutional constraints (many institutional investors face restrictions, which can lead to trends in asset prices), empirical evidence.
Factor diversification
The key element in the complementary nature of these factors when combined into a single portfolio. While individual factors experience their own cycles of outperformance and underperformance, their low correlations to each other create powerful diversification benefits. Factor diversification may provide a smarter approach to risk management than simply taking the market.
Left-tail risk protection
Below the results of a 600 Monte Carlo simulation conducted through the CURVO backtesting tool, providing evidence for the risk-reduction benefits of factor investing. These simulations model potential investment outcomes across numerous scenarios, giving us insight into not just average returns, but the full distribution of possible results.
Model trained on asset prices from Dec 1998 to Mar 2025
Monte Carlo – 600 runs
10k Eur invested, net asset value after 30 years, percentiles reported
Model trained on asset prices from Dec 1998 to Mar 2025
Monte Carlo – 600 runs
10k Eur invested, net asset value after 30 years, percentiles reported
| Percentile | Net asset value | Compound annual growth rate | Standard deviation |
|---|---|---|---|
| Large (2σ) | 319.767 € (319.390 €) | 12,24% (12,24%) | 8,35% (15,08%) |
| Good (σ) | 205.705 € (141.967 €) | 10,61% (9,25%) | 8,48% (15,01%) |
| Media | 124.368 € (62.343 €) | 8,77% (6,29%) | 9,09% (13,79%) |
| Bad (-σ) | 79.228 € (29.292 €) | 7,14% (3,65%) | 8,50% (14,79%) |
| Very bad (-2σ) | 53.125 € (12.777 €) | 5,72% (0,82%) | 8,80% (14,42%) |
Monte Carlo – 600 runs
(Benchmark reported in brackets)
Some insights emerge:
- Tighter return distribution: the factor portfolio exhibits a noticeably narrower distribution.
- Reduced downside: the factor portfolio shows significantly reduced left-tail risk. Notice how the benchmark distribution extends further into negative returns.
- Improved Sharpe: while the factor portfolio matches the extreme positive benchmark returns in the best scenarios, it delivers a higher average return (8.77% vs 6.29%) with lower standard deviation (9,09% vs 13,79%).
It isn’t just about chasing returns, but about engineering a more resilient portfolio given the returns that we want. By narrowing the distribution of outcomes and specifically reducing the magnitude of negative scenarios, factor exposure creates a more favorable risk-return profile.
Maybe.