Factor investing can be a challenging topic to navigate.
With an alphabet soup of terms and explanations, it is easy to lose sight of the bigger picture when seeking to understand what is behind a factor-based investment approach.
In this article, the first in a three-part series, we hope to shine a light on factor investing, explaining some of the history, key concepts and drivers behind this investment style.
Put simply, factor investing is an investment approach that involves targeting quantifiable characteristics or "factors" that can explain differences in security returns.
A factor-based investment strategy will tilt a portfolio towards or away from specific factors, seeking to harness favourable characteristics in order to generate additional return, or reduce risk, in comparison with the wider market.
Factors are a set of properties common to a broad set of securities, and a factor-based strategy will typically approach these in a systematic and rules-based manner.
Its focus on longer-term characteristics and its rules-based mindset is one of the key distinctions when compared with traditional active strategies.
The approach is quantitative and based on observable data, including security prices and financial information, rather than on opinion or speculation.
Key criteria
As outlined in the book Your Complete Guide to Factor-Based Investing, industry pioneers Andrew Berkin and Larry Swedroe note that to be worthy of exposure a factor should meet a number of criteria.
First, it should be persistent, with the factor working across long periods of time and different economic regimes.
Next, it should be pervasive – the factor should work across countries, regions, sectors, and even asset classes.
Alongside this it should be robust – it should work for different definitions of the factor (for example, working for both price/equity and price/book for the value factor).
It should also be investable – not just working on paper, but also after considering implementation issues like trading costs.
Finally, the factor should be intuitive, with there being logical risk-based or behavioural-based explanations for its premium and why it should continue to exist.
The origins of factor investing lie in the capital asset pricing model, introduced by William Sharpe, with its focus on a single factor (beta) in explaining investment returns.
Over the years there have been many contributions in the literature expanding upon this.
These include Stephen Ross’s arbitrage pricing theory, which made the case for security returns being best explained by multiple factors.
Eugene Fama and Kenneth French made a seminal contribution with the introduction of their three-factor model, adding the value and size factors alongside beta.
This was then expanded upon by Mark Carhart to include a fourth factor: momentum.
Standing today, although the case can be made for a wider range of different factors, academics and practitioners have broadly coalesced around the following set of five widely accepted factors:
