To develop screeners, many investors both large and small, use a series of “factors” as the core constituents for their strategy. Factor investing is a strategy that chooses securities on attributes that are associated with higher returns. There are two main types of factors that have driven returns of stocks, bonds, and other factors: macroeconomic factors and style factors. The former captures broad risks across asset classes while the latter aims to explain returns and risks within asset classes.

To call a factor “good” or “bad”, we would expect to see a consistent disparity in companies in the best and worst deciles when compared to one another. For example, to test the price-to-earnings (P/E) ratio, we would take every company in the S&p 500 over the years and measure its market cap divided by its profits it receives. This would get us the companies’ P/E ratios. Companies with a low P/E ratio are suggested to be undervalued because they earn more money than their market cap would warrant. The “best” 10% of S&P 500 companies by this measure would then be compared to the “worst” 10% of that same pool of companies and their annual returns over the span of Jan 1st, 2000 to today would be compared. If the top decile of S&P 500 companies (in this case 50 companies) outperform the bottom decile, we would log the difference in annualized returns.