|Course 506: Factor Investing|
Eugene Fama and Kenneth French "fixed" the CAPM, at least for stocks, by adding two factors: size and value. They observed that smaller stocks outperformed larger stocks and stocks with high book/market outperformed stocks with low book/market. More importantly, the relationships were smooth; the smaller or more value-laden the stock, the higher its return. Fama and French interpret the smoothness of the relationship as indicating the market is rationally "pricing" these attributes, which implies that size and value strategies enjoy higher expected returns for being riskier.
Further research has uncovered more stock factors, including momentum, quality, and low volatility, in nearly every equity market studied. They also display the same smooth relationship: The stronger the factor attribute, the higher the excess returns. The interpretation of these factors depends on whether you believe the market is efficient. In an efficient market, they must be connected to risk. However, if the market is not perfectly rational, some may represent quantitative strategies that exploit mispricings to produce excess returns.
Many practitioners don't believe value, quality, momentum, and low-volatility strategies work because they are riskier. The strategies were exploited by investors before academics published them in journals as "discoveries." It's also hard to reconcile them all as representing risk because if you lump them all together, you get a smooth return stream.
This does not mean that all factors earn profits by identifying mispricings. Some attributes, such as illiquidity, are associated with higher returns because they obviously represent risk. So factor investing encompasses two different approaches:
1. Rational factor theory, which deals with the rewards that accrue to different types of risk and how the market prices them. Factor investing in this context is about finding the optimal portfolio of factor risks.
2. Factor investing as commonly understood by practitioners, which is the identification of simple quantitative strategies associated with excess returns.
Though it's been around for decades, factor investing has only in the past decade gained adherents. Recent converts include the Government Pension Fund of Norway, the biggest pension fund in Europe, and CalPERS, the biggest public pension fund in the United States.
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