Factor investing is an investment approach that involves targeting quantifiable firm characteristics or “factors” that can explain differences in stock returns. Over the last fifty years, academic research has identified hundreds of factors that impact stock returns. Security characteristics that may be included in a factor-based approach includes size, value, momentum, asset growth, profitability, leverage, term and carry.
A factor-based investment strategy involves tilting equity portfolios towards and away from specific factors in an attempt to generate long-term investment returns in excess of benchmarks. The approach is quantitative and based on observable data, such as stock prices and financial information, rather than on opinion or speculation.
History and evolution
The earliest theory of factor investing originated with a research paper by Stephen A. Ross in 1976 on Arbitrage Pricing Theory, which argued that security returns are best explained by multiple factors. Prior to this, the Capital Asset Pricing Model (CAPM), theorized by academics in the 1960s, held sway. CAPM held that there was one factor that was the driver of stock returns and that a stock’s expected return is a proportion beta of that factor, or sensitivity to equity market returns.
In the following decades, academic research has identified more factors that impact stock returns. For example, in 1981 a paper by Rolf Banz established a size premium in stocks: smaller company stocks outperform larger companies over long time periods, and had done so for at least the previous 40 years.
In 1993, Eugene F. Fama and Kenneth B. French published a seminal paper that demonstrated a value premium, or the fact that expected returns of value stocks were higher than for growth stocks. The roots of value investing date to decades earlier with the work of Benjamin Graham and David Dodd as outlined in their 1934 book Security Analysis, and their student Warren Buffett outlined their findings and application in his 1984 article "The Superinvestors of Graham-and-Doddsville".
In 1993, Sheridan Titman and Narasimhan Jegadeesh showed that there was a premium for investing in high momentum stocks. Other significant factors that have been identified are measures of corporate profitability, asset growth, external financing, leverage and research and development costs.
The value factor
The earliest and most well-known factor is value, which can be defined primarily as change in the market valuation of earnings per share ("multiple expansion"), measured as the PE ratio. The opportunity to capitalize on the value factor arises from the fact that when stocks suffer weakness in their fundamentals, the market typically overreacts to it and values them extremely cheaply relative to their current earnings. A systematic quantitative value factor investing strategy therefore buys those stocks at their cheapest point and holds them until the market becomes less pessimistic about their prospects and re-values their earnings.
- Fisher, Gregg; Shah, Ronnie; Titman, Sheridan (2015-03-23). "Combining Value and Momentum". Journal of Investment Management. 14. SSRN 2472936.
- Harvey, Campbell R.; Liu, Yan; Zhu, Heqing (2016-01-01). "… and the Cross-Section of Expected Returns". Review of Financial Studies. 29 (1): 5–68. doi:10.1093/rfs/hhv059. ISSN 0893-9454.
- Swedroe, Larry (2016-10-07). Your Complete Guide to Factor-based Investment. ISBN 978-0692783658.
- Fama, Eugene F.; French, Kenneth R. (1992). "The Cross-Section of Expected Stock Returns". The Journal of Finance. 47 (2): 427–465. CiteSeerX 10.1.1.556.954. doi:10.2307/2329112. JSTOR 2329112.
- Maymin, Philip; Fisher, Gregg (2011-04-11). "Past Performance is Indicative of Future Beliefs". Risk and Decision Analysis. 13 (3): 145–150. doi:10.3233/RDA-2011-0038. S2CID 15665310. SSRN 1746864.
- Ross, Stephen A. (1976). "The Arbitrage Theory of Capital Asset Pricing" (PDF). Journal of Economic Theory. 13 (3): 341–360. doi:10.1016/0022-0531(76)90046-6.
- Wei, K. C.; Xie, Feixue; Titman, Sheridan (2003-09-01). "Capital Investments and Stock Returns". The Journal of Financial and Quantitative Analysis. 39 (4): 677–700. doi:10.1017/S0022109000003173. SSRN 441584.
- Novy-Marx, Robert (2013). "The other side of value: The gross profitability premium". Journal of Financial Economics. 108 (1): 1–28. CiteSeerX 10.1.1.646.914. doi:10.1016/j.jfineco.2013.01.003. ISSN 0304-405X.
- BANZ, Rolf W. (1981). "The relationship between return and market value of common stocks". Journal of Financial Economics. 9: 3–18. CiteSeerX 10.1.1.554.8285. doi:10.1016/0304-405X(81)90018-0.
- Fama, E. F.; French, K. R. (1993). "Common risk factors in the returns on stocks and bonds". Journal of Financial Economics. 33: 3–56. CiteSeerX 10.1.1.139.5892. doi:10.1016/0304-405X(93)90023-5.
- Jegadeesh, Narasimhan (July 1990). "Evidence of Predictable Behavior of Security Returns" (PDF). The Journal of Finance. 45 (3): 881–898. doi:10.1111/j.1540-6261.1990.tb05110.x.
- Jegadeesh, Narasimhan; Titman, Sheridan (1993). "Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency". The Journal of Finance. 48 (1): 65–91. CiteSeerX 10.1.1.597.6528. doi:10.1111/j.1540-6261.1993.tb04702.x. JSTOR 2328882.
- Bollen, Nicolas; Fisher, Gregg (2012-07-03). "Send in the Clones? Hedge Fund Replication Using Futures Contracts". The Journal of Alternative Investments. 16 (2): 80–95. doi:10.3905/jai.2013.16.2.080. S2CID 219222562. SSRN 2102593.
- Fisher, Gregg S.; Shah, Ronnie; Titman, Sheridan (2017-10-31). "Should You Tilt Your Equity Portfolio to Smaller Countries?". The Journal of Portfolio Management. 44 (1): 127–141. doi:10.3905/jpm.2017.44.1.127. ISSN 0095-4918. S2CID 158439399.
- "Factors from Scratch | O'Shaughnessy Asset Management". osam.com. Retrieved 2018-09-06.