- 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. 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.
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 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. 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:
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.)
- 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
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 FactorsHT: Barron's Focus on Funds
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, 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