From GersteinFisher's Viewpoints:
- Factors
are observable and quantifiable firm-level characteristics that can
explain differences in stock returns. Factor-based investing involves
building portfolios with exposures to certain factors that may
compensate investors with excess returns over the long run.
- Multi-factor
investing has distinct advantages for long-term investors over both
passive indexing and traditional active management.
- Building a factor-based strategy and optimizing the factor mix is quite complex.
I regard some of my success in investment management as stemming from
the serendipity of graduating from college and founding Gerstein Fisher
in the same year that William Sharpe, as well as Eugene Fama and Ken
French, published two seminal papers that gave rise to quantitative
multi-factor investing.[1]
What’s more, dramatic advances in computing power at that time (the
early 1990s) were enabling quantitative investment managers to organize
and analyze vast amounts of information to construct factor-based
investment strategies in a highly disciplined and mathematical fashion.
Gerstein Fisher did not invent factor-based investing, but we were
among the first to translate academic theory into practical solutions
for investors via multi-factor strategies. Not surprisingly, I am a
passionate believer that quantitative multi-factor investing—which I
might call a third way of investing–has distinct potential advantages
for long-term investors over both passive indexing and traditional
active investing. But I’m also aware that factor investing is less
familiar and may seem opaque to some investors. For this reason, with
this entry I am inaugurating a comprehensive, multi-part series on
multi-factor investing that can serve as a primer to equip readers with a
greater understanding of this exciting and rapidly evolving field. So
let’s get started.
Compensated Risks
First, what is a factor? Factors are observable and quantifiable
firm-level characteristics that can explain differences in stock
returns. A large body of academic research[2]
demonstrates that over the long term, returns of an equity portfolio
can almost entirely be explained through the lens of these investment
factors (some factor examples are value and momentum). Andrew Ang, a
finance professor at Columbia University, has an insightful analogy to
help explain factors: factors are to investment assets as nutrients are
to food.[3]
For example, much as we eat foods for their underlying nutrients—soy
beans for protein, nuts for healthy oils, grains for fiber—to the
quantitative investment manager it’s the investment factors that compose
the assets that really matter, not the assets themselves. Just as foods
are bundles of nutrients, securities are bundles of factors.
Compelling and successfully implemented factors typically share the following characteristics:
- Abundant academic evidence and a strong theory based on financial or
economic logic for why it works (i.e., empirical evidence alone is
insufficient) and is expected to work in the future
- The theory may be risk-based, behaviorally based, or a combination of both
- Can explain differences in returns in different industries, countries, and markets over long time periods
- Able to be implemented in liquid, tradable securities
Exhibit 1 names and briefly describes eight distinct, important
investment factors. (Note that this is hardly an exhaustive list, but
encompasses some commonly researched and implemented factors.)
Factor-based investing involves building portfolios with deliberate
exposures, or tilts, to certain factors, or risks, that research has
shown compensate patient investors with excess returns (relative to the
relevant benchmark) over the long run, and tilting away from
uncompensated risk factors. For example, in Gerstein Fisher’s domestic
Multi-Factor® Growth Equity strategy we maintain a positive tilt to the
profitability and momentum factors (versus the Russell 3000 Growth
Index), but negative exposure to capital expenditures and the
fastest-growing small companies. Information from both company
fundamentals and market prices are used to calculate numerous factor
scores for each company (each security has characteristics that make it
different from the profile of the market average). Exhibit 2 compares
actual scores for two companies. Interestingly, the scores (for just
seven of many factors) and compounded returns are remarkably similar
despite the fact that the securities are in entirely different
industries.
Harvesting Factors
Conceptually, a multi-factor strategy seeks to generate superior
long-term risk-adjusted returns relative to a benchmark by collecting
risk premiums in a systematic, targeted way through strategic tilts
toward securities with desirable factor exposures. Much as equity
investors have collected an annual risk premium of 6.6% historically for
putting money into volatile stocks rather than into virtually risk-free
Treasury bills[4],
factor-oriented investors seek to collect factor premiums as a reward
for holding factors through the bad times (remember that risk and return
are related)....MORE
HT: Barron's
Focus on Funds
