The Definitive Book on Factor Investing
Advisor Perspectives welcomes guest contributions. The views presented here do not necessarily represent those of Advisor Perspectives.
Smart beta. Empirical finance. Evidence-based investing. These terms, which were in the periphery of the investment vernacular just 10 years ago, have become the investment world’s most popular memes today. Why?
Investors have been disenfranchised from traditional forms of active management. After all, performance-obsessed investors can’t fail to notice that a majority of active mutual funds in almost every category consistently fail to outperform their passive benchmarks, year after year, over every meaningful investment horizon.
Factor-based investing replaces stock-picking guru
What is factor-based investing? Larry Swedroe and Andrew Berkin offer an incredibly comprehensive answer in their newest book, Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today. In nine dense chapters complemented by 10 detailed appendices, Swedroe and Berkin provide a broad and deep overview of the most salient factor literature, replete with over 100 citations from the most respected academics and practitioners in the field.
If a factor you’re considering can’t be found in this book, it isn’t worth considering.
Factor-investing godfather Cliff Asness, a founding partner of the Connecticut-based investment firm AQR, wrote the foreword to the book. Asness defines factor-based investing as “defining and then systematically following a set of rules that produce diversified portfolios.” Consistent with the general tone of the book, Swedroe and Berkin make this concept more concrete. They describe factor-based investing as “in part about the academic community’s search for that secret sauce – specifically, the characteristics of stocks and other securities that both explain performance and provide premiums (above market returns).”
These definitions move us closer to an understanding of what factor-based investing is about, but there is still a great deal of ambiguity. After all, the factor literature extends back over half a century. Dozens of papers have identified hundreds of potential factors. Some prominent practitioners have described factor-based investing as a “zoo,” in reference to myriad exotic factors that appear to have little practical substance.
What factors should I consider, and why?
Perhaps the book’s greatest contribution is the framework the authors propose to evaluate the factors. Each factor is subjected to a rigorous analysis under this framework to determine if it is worthy of investors’ attention. Specifically, all worthy factors must:
- Be persistent over a long period of time and across several market cycles
- Be pervasive across a wide variety of investment universes, geographies and sometimes asset classes
- Be robust to various specifications
- Have intuitive explanations grounded in strong risk and/or behavioral arguments, with reasonable barriers to arbitrage
- Be implementable after accounting for market impacts and transaction costs