Foundations of factor investing

By Altaf Kassam

‘Factor investing’ has become a widely discussed part of today’s investment canon. However, before an investor can select and allocate among factors, it is important to understand what a ‘factor’ is.

A factor is any consistent characteristic that is important in explaining the returns and risk associated with a group of related securities.  A large body of academic research has highlighted that long-term equity performance may be explained through factors. This research is not new; and has been prevalent for over 40 years.

And how are they grouped?

The many factors identified over time can be grouped into three broad categories: macroeconomic, statistical, and fundamental.[1]  From thousands of identifiable factors, a few have proven global efficacy through offering increased return and/or reduced volatility over the long term.  In other words, these factors contain a risk premium relative to a capitalisation-weighted market index.  Some risk premium factors include value, low size, low volatility, high yield, quality and momentum. Factor investing is the investment process that aims to harvest these risk premia through exposure to factors.

However, persistent factors described by academics often entail assumptions that are difficult to capture in practical real-life portfolios.  They generally do not systematically consider features that are key to actual implementation: transactions costs, liquidity, investability and capacity.  Therefore, the ability to capture risk premia factors could only reasonably be done by active managers.

So how can this be managed?

Recently, providers have designed practical indexes to harvest the risk premia associated with specific factors, while explicitly incorporating investability considerations through systematic low-cost indexes.[2]  MSCI has developed an investable family of factor indexes, which seek to reflect widely accepted systematic risk premia identified by the investment community.

Indexation has provided a powerful way for investors to access factors in cost-effective and transparent ways. Factor allocations can be implemented using factor indexes, which may bring potential cost savings to institutional investors.  Factor indexes also bring transparency to factor allocations, which helps alleviate the well-known problem of manager style drift and has positive implications for risk management.

So how do you choose between factor indexes?

When capturing risk premia and incorporating them into factor indexes, critical decisions include the choice of the security universe, the choice of the weighting scheme, and the rebalancing frequency. The closest to market capitalisation weighted indexes are the High Capacity Factor Indexes. These are indexes that hold all the stocks in the parent index but use a different weighting scheme from market capitalization weighting. High Exposure Factor Indexes can narrow to a subset of stocks by various methods – for example, optimisation or screening can be used.   Next, Long/Short Factor Indexes add leverage (e.g., 150/50, 130/30) and typically employ optimisation, and lastly Market-Neutral Factor Indexes are pure long/short indexes that have zero market exposure.[3]

In conclusion, some investors will prefer higher capacity approaches for their lower tracking error, investability, and simplicity, while others will prefer the higher exposure approaches for their stronger signal strength and potential return enhancement.

Altaf Kassam, managing director of Index Applied Research for EMEAI at MSCI