Wait, Tesla is a value stock? Welcome to the wacky world of factor ETFs

That’s one of the most subtle, but important, lessons of 2025. As exchange-traded funds have become the default choice for millions of investors, it’s vital to understand that you can’t know what you’re going to get unless you take the time to look inside first.

To see what I mean, consider factor ETFs, also called smart-beta funds. What’s a “factor"? It’s a set of characteristics, shared by large numbers of companies, that shape risk and return—for example, value or momentum.

Academic research has shown that many factors have outperformed the overall market over the long run.

In the short run, results at funds pursuing a similar strategy can vary wildly. Last year, iShares MSCI USA Momentum Factor, which targets stocks with high recent returns, gained 22.1%. Alpha Architect US Quantitative Momentum ETF, which also favors stocks with hot performance, was up only 2.6%.

Returns were also widely dispersed at funds based on other factors, such as value (statistically inexpensive stocks), quality (companies with high profitability and low debt), and minimum volatility (stocks whose prices fluctuate less than the overall market). Among funds with similar names and objectives, return differences of 10 percentage points or more were common in 2025.

In fact, funds that invest in the same factor have rarely performed in lockstep, says Nicolas Rabener, founder of Finominal, an investment-research firm in London. Wide gaps among look-alike funds are the rule, not the exception.

That’s because different ETF managers define the same factor in drastically divergent ways. The value factor, for instance, focuses on cheap stocks. But a fund manager can define “cheap" as having lower multiples of earnings, sales, assets or cash flow—or still other measures or combinations of measures. The potential variations are almost endless.

Why would you want to own a factor fund? You could have an insight—or a hunch—that a particular part of the market is set to outperform. Or you could be underexposed or overexposed to particular stocks or industries.

“Financial advisers often have a significant bias toward value and small-cap stocks in the portfolios they build for clients, so many investors would be well-served to be more diversified across multiple factors," says Jay Jacobs, U.S. head of equity ETFs at BlackRock.

Or maybe you manage your own portfolio. Let’s say that 90% of your stock exposure is through a total-market index fund, but you have another 10% of your money in Tesla shares. Tesla is trading at roughly 290 times its earnings over the past 12 months. In the long run, it might grow enough to justify that high valuation, but you’re making a big bet.

You might, therefore, want to buy a value-factor ETF to balance out your high exposure to growth through Tesla.

Yet, although Tesla sounds like the polar opposite of a value stock, it meets the technical definition of “value" at the indexes that several funds use as benchmarks. So such ETFs as Fidelity Value Factor, iShares Morningstar Value, iShares S&P 500 Value and State Street SPDR Portfolio S&P 500 Value all hold it as a top-10 position.

Meanwhile, other funds, such as Schwab U.S. Large-Cap Value, own little or no Tesla.

So the first thing you should do when shopping for a factor fund is look at its list of holdings to see whether they match what you’re trying to achieve.

Next, be realistic. “Factors work over the long run, but they can’t work all the time," says Scott Rodemer, head of factor-based strategies at Vanguard.

Any given factor, no matter how well it has done in the past, can underperform the overall stock market—not just for years, but decades. Or it can generate superior long-term returns from remarkably short bursts of outperformance.

Nearly all the excess return of small stocks over the past century, according to financial researcher Edward McQuarrie, came during only four years: 1933, 1943, 1945 and 1967.

Bear in mind, too, that factor investing is a form of what I’ve called deversification, or reducing how diversified you are. By focusing on only a segment of the market, you concentrate your bets instead of spreading them.

By regulation, a fund with a specific factor in its name is generally required to invest at least 80% of its assets in a way that’s consistent with the name. That means that most of your money will follow that factor rather than the stock market as a whole.

On the other hand, the other 20% can go pretty much wherever the managers choose. Many funds that purport to invest in a single factor sneak in exposure to others, too, says Wesley Gray, chief executive of Alpha Architect, an ETF firm in Newtown Square, Pa. Otherwise, he says, their short-term performance could deviate so far from the S&P 500 that it would be “literally insane."

Some ETFs, called multifactor funds, explicitly hold a variety of strategies. Although they slightly outperformed in 2025, multifactor funds trailed the S&P 500 by an average of 2.1 percentage points annualized over the past five years, according to Morningstar. (That average is weighted by each fund’s size to ensure a fair comparison.)

At many of these funds, owning all the factors that make up the entire market added up to a whole that was less than the sum of its parts.

There’s nothing wrong with buying a factor fund to fill in the gaps in your portfolio if you aren’t fully diversified. If you already are, then trying to figure out which factor will do the best, or which fund will best represent the factor, probably isn’t worth the bother.

Write to Jason Zweig at intelligentinvestor@wsj.com