Factor investing, plainly
Much of what professional "quant" funds do rests on a handful of traits that researchers found in share prices decades ago. Knowing them turns a lot of fund marketing into plain words.
What a factor is
A factor is a trait shared by many companies that has, over long periods, gone with different returns. In 1992 and 1993 Eugene Fama and Kenneth French showed that small companies and "value" companies, cheap compared with their accounts, had earned more than the market alone explained.
Momentum
Shares that have risen most over the past year have tended to keep rising for a while, and the weakest to keep lagging. Narasimhan Jegadeesh and Sheridan Titman documented it in 1993; Mark Carhart added it to the standard model in 1997.
Quality and low volatility
Profitable, steady companies have done better than their risk suggested (Robert Novy-Marx, 2013). So, oddly, have calmer shares compared with jumpy ones (Andrea Frazzini and Lasse Pedersen, 2014). A fund that says it buys "quality" or "low volatility" is leaning on these findings.
How funds use them
Factor funds, sometimes called smart beta, hold a whole market but tilt towards one trait, by a written rule rather than a manager’s view. Their costs usually sit between an index fund and an active fund. The rule is in the prospectus, so you can see what you are getting.
Where it bends
A factor can lag for years, long enough for most people to give up. And once a pattern is published, money chases it: a 2016 study of 97 such findings found their returns were on average 58% lower after publication. A tilt is a bet on a pattern continuing, not a free extra.
Key takeaways
- Factors are traits like value, size, momentum, quality and calm that went with different returns.
- Factor funds follow a written rule; read it in the prospectus.
- Factors can lag for years, and published edges tend to shrink.