Factor investing took off about 10 years ago, rooted in a vast body of empirical research accumulated over the prior decades. The asset pricing literature showed that factors such as size, value, and momentum explain the cross section of stock returns, while the mutual fund literature found little evidence for managerial skill beyond tilting toward factors. Taken together, these insights argue for harvesting factor premiums in a systematic, efficient manner. In an influential study commissioned by the Norwegian government pension fund, Ang, Goetzmann, and Shaefer (2009) even recommended including factor premiums in the strategic asset allocation, next to traditional asset class risk premiums. Although asset owners have generally been hesitant to go that far, factor investing has become an established investment approach. While quantitative investing has been around much longer, factor investing tends to make the choice of factors and their desired weights more explicit.
The fundamental difference between asset class risk premiums and factor premiums is that the former can be captured by following passive, capitalization-weighted indices with low turnover, while the latter are active investment strategies at heart. Index providers have attempted to commoditize factor strategies by introducing smart beta indices (also known as alternative beta indices), but these require various subjective choices, for example, regarding the factor definitions, weighting schemes, and rebalancing schedules. Factor indices do offer the benefit of simplicity and transparency and can serve as a benchmark for the evaluation of actively managed factor strategies.
Factor investing is sometimes referred to as risk factor investing, based on the notion that any premium must be a reward for some form of systematic risk. If factor premiums are indeed risk premiums, then they can be expected to persist in the future. Taking the value factor as an example, however, it is unclear why value stocks should command a risk premium over growth stocks but not the other way around, because both appear to be about equally risky using common risk metrics. An alternative explanation for the existence of factor premiums is that behavioral biases of investors cause systematic mispricing effects. These biases could stem from irrational behavior but might also be rationally induced by the institutional environment, such as incentive structures and regulatory frameworks. Given that such ambiguity applies to most factors, we prefer to stick to the shorter and more neutral term factor investing.
But how should the theory of factor investing be implemented in practice? The remainder of this article attempts to answer this question by discussing the selection of factors, how to combine them, and portfolio construction. Finally, we discuss next-generation developments in the factor investing space.
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