Factor Investing Primer Series: What Is a Factor?

Factor investing, sometimes referred to as smart beta or enhanced indexing, is rooted in academic research. In their attempts to better understand the market, researchers have uncovered a number of persistent anomalies in the market. They sought to explain, then systematically exploit these “factors” in the market. As the breadth of this research evolved, researchers settled upon a broadly agreed-upon definition of just what a factor was.

Factors are defined as a source of excess return that is sensible, persistent over long time periods, pervasive across markets, and cost-effective to capture.

This relatively simple definition has held up well over time as research into factors has exploded. Thousands of factors have been identified by researchers, though the vast majority of those factors don’t meet all criteria of the definition. For example, a writer at Bloomberg jokingly created a Cat factor, which invested in stocks with “cat” in the name, which in the period and region he tested on, generated enormous returns. However, this “factor” failed the definition across the board. First, there is no economically sensible reason cat-named stocks would outperform other stocks. After the initial trial, it turns out the outperformance was neither pervasive across markets nor persistent over different time periods.

Evolution of Factors Research

To understand factor investing, it may be worthwhile to take a step back and look at the evolution of investing. Historically, there were two approaches to investing, active and passive. Active investing has the allure of generating above-market returns. However, this came at a cost. First, the costs were generally higher as it is expensive to pay the talent needed to beat the market. Second, active trading generates high transaction costs and tax inefficiency. Active investors believe there are inefficiencies in the market that they can exploit. As seen in the below chart, the track record of active investors indicates they are unable to systematically beat the market.

A second approach, passive investing (often referred to as indexing), admitted that the higher costs associated with the active investing were a barrier to outperformance, and further believed that what inefficiencies there are in the market are not actionable in a profitable way. As a result, they closely follow a benchmark and take the market return, less costs (which as a result of this approach, are much lower). This approach is much more tax efficient as indexing does not result in substantial churn in the portfolio.

Is There a Better Way?

Many researchers believed there had to be a better way. This led to a bevy of research now referred to as factor investing. In broad strokes, factor investing takes active concepts, but implements in a passive way, achieving some of the strengths of both approaches, namely above-market returns, while maintaining low cost and tax efficiency. Additionally, combining factors is diversifying, providing a smoother ride for investors while still providing better long-term returns.

BDF has taken this research and added four factors to our portfolio: small, value, momentum and profitability. Look for future posts describing in more detail each of the four factors described above.

 

^{Note: The Standard & Poor’s Indices Versus Active Funds (SPIVA) Scorecard keeps quarterly tabs on the active-versus-passive debate. This report shows performances of actively managed mutual funds as compared to Standard & Poor’s indices in their respective style or sector categories. Apples-to-apples comparison: Fund returns are often compared to popular benchmarks such as the S&P 500, regardless of size or style classification. An appropriate comparison would be to measure a fund’s returns against the returns of a benchmark for that particular style and size category.}