Over the past five years, the percentage of U.S. stocks represented in the most popular global indices has grown substantially. The so-called “Magnificent Seven” – a handful of technology giants¹ – have come to dominate major indices like the S&P 500 and MSCI World².
These U.S. tech companies have undoubtedly delivered strong returns³. However, their high concentration in global stock indices raises questions about portfolio construction – the process of selecting and combining different investments to build a diversified portfolio.
This creates portfolios that are far less diversified than they might appear on the surface. A phenomenon generally referred to as concentration risk, as portfolios largely depend on the development of only a few numbers of stocks.
So; what happens when a small number of stocks drive the majority of a portfolio’s performance? Are there other ways to build less concentrated – that is, more diversified – exposures?
Factor investing can offer a compelling alternative.
Traditional indices might give more weight to bigger companies, which means your investment could depend heavily on a few large firms. This can increase risk if those companies perform poorly. Factor investing takes a different approach: it selects stocks based on characteristics like value, quality, or size, aiming to improve returns and manage risk.
These characteristics have the potential to compensate investors with higher returns and have consistently influenced how a company’s stock performs over time. By following clear rules, factor investing can help diversify your portfolio beyond just company size.
What is Factor Investing?
According to extensive research, factors have historically led to better risk-adjusted returns over time across different time periods and market conditions⁴. Risk-adjusted returns compare how much profit was made relative to the risk taken, which makes it easier to compare investments that exhibit different levels of risk. Factor methodologies – which apply consistent, pre-defined rules to select stocks based on specific characteristics rather than just size – go beyond traditional weighting approaches, where index constituents are weighted based on their market capitalisation.
The market cap is the total value of a company’s outstanding shares of stock. Instead of simply giving larger companies more weight in the portfolio because of their size – which is what many well- known indices do – factor strategies select and weight stocks based on characteristics like value, quality, or momentum.
These strategies maintain the benefits of systematic, rules-based investing – an approach where investment decisions follow pre-defined quantitative rules rather than subjective judgment, ensuring consistency and removing emotional bias from the investment process.
Five well-established investment factors
While there are hundreds of different factors, five of them have proven particularly robust and accessible to investors. Each targets different aspects of company fundamentals or market behaviour:
- Quality: This factor looks at companies with strong financial health – lower debt levels, stable earnings, and steady growth compared to their peers. Think of these as very well-maintained companies that run smoothly, even during challenging market phases. Quality companies often show higher returns on equity, better debt coverage, and efficient use of money compared to other companies.
- Value: This factor looks for companies that seem undervalued — meaning their stock price seems low compared to what the business is really worth. To find stocks that appear relatively cheap compared to their underlying business value, this approach uses several key metrics, such as:
- Price-to-Book Ratio: Compares a company’s share price to its book value per share (the company’s total shareholder equity divided by the number of outstanding shares).
- Price-to-Earnings Ratio: Compares a company’s share price to the company’s earnings per share (profits).
The goal is to buy stocks that seem underpriced today, with the expectation that their price will rise back to their true or ‘intrinsic’ value over time– the theoretical worth of a company’s share price based on its fundamentals like earnings, cash flow, and growth potential, rather than what the market currently thinks it’s worth.
- Momentum: This factor is based on the idea that stocks that have done well recently often keep doing well for a while. It looks for companies whose share price has risen more than their peers’. Momentum-based strategies systematically buy more of these stocks while reducing exposure to those with weaker recent performance.
- Minimum Volatility: This factor seeks to reduce big ups and downs in a portfolio. It focuses on stocks that have shown lower price swings in the past. But it doesn’t simply pick the least volatile stocks. Instead it constructs a portfolios that aims to keep overall risk low while maintaining broad market exposure. Low volatility portfolios may help investors achieve their goals with less pronounced up- and downturns. However, this may lead to slightly lower returns over the long term.
- Size: The size factor focuses on smaller companies, often called small-cap stocks. Historically, these companies have shown the potential for higher returns than large companies⁵. This effect is often referred to as the “small-cap premium” and is supported by academic research. However, results can vary because of market changes, liquidity constrains (how easily shares can be bought or sold), and economic conditions. Smaller firms may offer greater growth opportunities, but they also tend to be riskier, characterized by higher volatility and lower trading volumes.
How to use factors in practice
Understanding factors is one thing – integrating them strategically into a portfolio is another. Markets usually evolve through different periods of economic strength or weakness, changing regimes of monetary policy and fiscal policy, and times of political or geopolitical stability and instability.
Hence, markets tend to go in cycles, favoring different asset classes, industries and regions over time. When it comes to factors, their performance also changes with different market cycles. Some factors do well in certain markets, while others lag. Combining factor strategies therefore might be of particular value. You need to think about diversification, risk, and how factors interact with each other.
Factor performance and multi-factor approaches:
Factor investing has become accessible through exchange traded funds (ETFs) – investment funds that hold a collection of securities and trade on stock exchanges – that focus on different regional markets such as global, US, or European equities. Like individual stocks, factors can be difficult to time.
Over the long term, however, factors have shown the potential to achieve relatively better risk-adjusted returns compared to market cap weighted indices like the MSCI World. Rather than focusing on a single factor, some strategies combine multiple factors.
A combination of value and momentum factors, for example, has proven particularly useful in the past, as both factors can develop relatively independently from each other during crucial market phases. When factors move differently, the stronger-performing factors can help balance weaker ones during different market conditions⁶.
Considerations: Factor strategies can underperform traditional market cap weighted indices during certain periods. Like any investment approach, factor investing involves risks and should align with your personal investment goals and risk tolerance. It’s important to keep realistic expectations and maintain a long-term perspective.
Conclusion
Factor investing offers a systematic way to target specific return drivers. While no strategy guarantees success, factor investing provides a rules-based approach for portfolio construction and can help reduce some of the concentration risks present in today’s markets.
For investors seeking diversification beyond company size, factor investing can be a valuable consideration as part of a well-constructed portfolio strategy. As with any investment decision, thorough research and professional guidance remain essential.
You can find several Xtrackers products following the mentioned investment factor strategies here at InvestEngine.
This content is part of a sponsored partnership with Xtrackers by DWS.
Capital at risk. The value of your portfolio with InvestEngine can go down as well as up and you may get back less than you invest. ETF costs also apply.
This communication is provided for general information only and should not be construed as advice. If in doubt you may wish to consult a professional adviser for guidance.
Tax treatment depends on personal circumstances and is subject to change, and past performance is not a reliable indicator of future returns.
¹ The “Magnificent Seven” refers to seven large-cap U.S. technology stocks that have dominated market performance and valuations in recent years: Apple, Microsoft, Alphabet (Google), Amazon, Tesla, Meta (Facebook), and Nvidia. These companies are characterized by their massive market capitalizations, and significant influence on major stock indices.
² The S&P 500 is a stock market index tracking the 500 largest publicly traded U.S. companies by market capitalization, widely used as a benchmark for U.S. equity performance. The MSCI World is a global equity index covering approximately 1,600 large and mid-cap stocks across 23 developed markets, serving as a benchmark for international diversified equity portfolios.
³ MSCI, 2025, MSCI USA Information Technology Index (USD), accessed on 05 November 2025: https://www.msci.com/documents/10199/5b6344f1-be32-47d1-b05b-8145dfca925b. The MSCI USA Information Technology Index achieved an annualized gross return of 24.47% over the 10-year period ending September 30, 2025.
⁴ MSCI, 2025, Factor Indexing Through the Decades, accessed on 03 September 2025: https://www.msci.com/downloads/web/msci-com/research-and-insights/paper/factor-indexing-through-the-decades/factor-indexing-through-the-decades.pdf
⁵ MSCI, 2023, Small Caps Have Been a Big Story After Recessions, accessed on 05 November 2025: https://www.msci.com/research-and-insights/blog-post/small-caps-have-been-a-big-story-after-recessions
⁶ MSCI, 2025, Factor Indexing Through the Decades, accessed on 03 September 2025: https://www.msci.com/downloads/web/msci-com/research-and-insights/paper/factor-indexing-through-the-decades/factor-indexing-through-the-decades.pdf
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