Factor Investing Explained

In 1992, Eugene Fama and Kenneth French, professors at the University of Chicago Booth School of Business, expanded on Banz’ work and published “The Cross Section of Expected Stock Returns,” expanding the single-factor CAPM into a three-factor model for analyzing security performance. To this day, this is perhaps the most widely cited paper in financial economics.

Factor This

Factors are observable and quantifiable security-level characteristics that can explain differences in stock returns. Fama and French’s three-factor model identifies three characteristics that predict a stock’s performance:

• Beta, or overall market risk
• Size, with smaller companies throwing off higher returns than larger companies
• Value, measured as a security’s price-to-book ratio, with low-ratio stocks outperforming high-ratio stocks

In 1997, economist Mark Carhart posited a momentum factor (the tendency for a stock price to continue rising if it is going up and to continue declining if it is going down). More recently, Robert Novy-Marx (2012) and Fama/French (2015) have described additional factors, including profitability (stocks with a high operating profits tend to outperform) and investment (companies that invest aggressively in their business are more likely to outperform those that invest conservatively).

Numerous economists have demonstrated that, over the long term, returns of an equity portfolio can be explained almost entirely through a factor lens.

Columbia University finance professor Andrew Ang, author of “Asset Management: A Systematic Approach to Factor Investing,” uses an insightful analogy: Factors are to investment assets as nutrients are to food. Much as we eat foods for their underlying nutrients — meat or soybeans for protein, nuts for healthy oils, fruits and vegetables for vitamins and fiber — to the quantitative investment manager it is investment factors that really matter, not the assets themselves. Just as foods are bundles of nutrients, securities are bundles of factors.