Factor investing'''Factor investing''' is an [[Investment management|investment

approach]] that involves targeting quantifiable firm characteristics or “factors”

that can explain differences in stock returns. Security characteristics that may be
included in a factor-based approach include size, [[Low-volatility investing|low-
volatility]], [[Value investing|value]], [[Momentum investing|momentum]], asset
growth, profitability, leverage, term and carry.<ref>{{Cite journal |last1=Fisher |
first1=Gregg |last2=Shah |first2=Ronnie |last3=Titman |first3=Sheridan |date=2015-
03-23 |title=Combining Value and Momentum |journal=Journal of Investment Management
|volume=14 |ssrn=2472936}}</ref><ref>{{Cite journal |last1=Harvey |first1=Campbell
R. |last2=Liu |first2=Yan |last3=Zhu |first3=Heqing |date=2016-01-01 |title=… and
the Cross-Section of Expected Returns |journal=Review of Financial Studies |
language=en |volume=29 |issue=1 |pages=5–68 |doi=10.1093/rfs/hhv059 |issn=0893-9454
|doi-access=free}}</ref><ref>{{cite book |last1=Swedroe |first1=Larry |title=Your
Complete Guide to Factor-based Investment |date=2016-10-07 |publisher=BAM ALLIANCE
Press |isbn=978-0692783658}}</ref>

A factor-based investment strategy involves tilting investment portfolios towards

or away from specific factors in an attempt to generate long-term investment
returns in excess of benchmarks. The approach is quantitative and based on
observable data, such as stock prices and financial information, rather than on
opinion or speculation.<ref>{{Cite journal |last1=Fama |first1=Eugene F. |
last2=French |first2=Kenneth R. |date=1992 |title=The Cross-Section of Expected
Stock Returns |jstor=2329112 |journal=The Journal of Finance |volume=47 |issue=2 |
pages=427–465 |doi=10.2307/2329112 |citeseerx=10.1.1.556.954}}</ref><ref>{{Cite
journal|last1=Maymin|first1=Philip|last2=Fisher|first2=Gregg|date=2011-04-11|
title=Past Performance is Indicative of Future Beliefs |journal=Risk and Decision
Analysis|volume=13|issue=3|pages=145–150 |ssrn=1746864|doi=10.3233/RDA-2011-0038|
s2cid=15665310}}</ref> Factor premiums are also documented in corporate
bonds<ref>{{Cite journal |last1=Houweling |first1=Patrick |last2=van Zundert |
first2=Jeroen |date=2017 |title=Factor Investing in the Corporate Bond Market |
url=https://www.tandfonline.com/doi/full/10.2469/faj.v73.n2.1 |journal=Financial
Analysts Journal |language=en |volume=73 |issue=2 |pages=100–115
|doi=10.2469/faj.v73.n2.1 |issn=0015-198X}}</ref> and across all major asset
classes including currencies, government bonds, equity indices, and
commodities.<ref>{{Cite journal |last1=Baltussen |first1=Guido |last2=Swinkels |
first2=Laurens |last3=van Vliet |first3=Pim |date=2021 |title=Global Factor
Premiums |url=https://papers.ssrn.com/abstract=3325720 |journal=Journal of
Financial Economics |language=en |doi=10.2139/ssrn.3325720 |s2cid=159122441 |
ssrn=3325720}}</ref>

==History==
The earliest theory of factor investing originated with a research paper by Stephen
A. Ross in 1976 on [[arbitrage pricing theory]], which argued that security returns
are best explained by multiple factors.<ref>{{Cite journal|date=1976|title=The
Arbitrage Theory of Capital Asset Pricing|url=https://www.top1000funds.com/wp-
content/uploads/2014/05/The-Arbitrage-Theory-of-Capital-Asset-Pricing.pdf|
journal=Journal of Economic Theory|volume=13|issue=3|pages=341–360 |
doi=10.1016/0022-0531(76)90046-6|last1=Ross|first1=Stephen A.}}</ref> Prior to
this, the [[Capital Asset Pricing Model]] (CAPM), theorized by academics in the
1960s, held sway. CAPM held that there was one factor that was the driver of stock
returns and that a stock's expected return is a function of its equity market risk
or [[volatility (finance)|volatility]], quantified as beta. The first tests of the
[[Capital asset pricing model|Capital Asset Pricing Model (CAPM)]] showed that the
risk-return relation was too flat.<ref>{{Cite journal |author1=Black, F. |author2=
Jensen, M. C.|author3= Scholes, M. |date=1972 |title=The capital asset pricing
model: Some empirical tests |journal=Studies in the Theory of Capital Markets |
volume=81 |issue=3 |pages=79–121}}</ref>

Basu was the first academic to document a value premium in 1977.<ref>{{Cite journal
|last=Basu |first=S. |date=1977 |title=Investment Performance of Common Stocks in
Relation to Their Price-Earnings Ratios: A Test of the Efficient Market Hypothesis
|url=https://www.jstor.org/stable/2326304 |journal=The Journal of Finance |
volume=32 |issue=3 |pages=663–682 |doi=10.2307/2326304 |jstor=2326304 |issn=0022-
1082}}</ref> The roots of [[value investing]] date to decades earlier with the work
of [[Benjamin Graham]] and [[David Dodd]] as outlined in their 1934 book
''[[Security Analysis (book)|Security Analysis]]'', and their student [[Warren
Buffett]] outlined their findings and application in his 1984 article "[[The
Superinvestors of Graham-and-Doddsville]]". In 1981 a paper by Rolf Banz
established a size premium in stocks: smaller company stocks outperform larger
companies over long time periods, and had done so for at least the previous 40
years.<ref>{{Cite journal|last=BANZ|first=Rolf W.|title=The relationship between
return and market value of common stocks|date=1981|journal=Journal of Financial
Economics|volume=9|pages=3–18|citeseerx=10.1.1.554.8285|doi=10.1016/0304-
405X(81)90018-0}}</ref>

In 1992 and 1993, [[Eugene F. Fama]] and [[Kenneth French]] published their seminal
three-factor papers that introduce size and value as additional factors next to the
market factor.<ref name="FamaFrench1993">{{Cite journal | last1 = Fama | first1 =
E. F. | author-link1 = Eugene Fama| last2 = French | first2 = K. R. | author-link2
= Kenneth French| doi = 10.1016/0304-405X(93)90023-5 | title = Common risk factors
in the returns on stocks and bonds | journal = [[Journal of Financial Economics]]|
volume = 33 | pages = 3–56 | year = 1993 | citeseerx = 10.1.1.139.5892}}</ref> In
the early 1990s, Sheridan Titman and Narasimhan Jegadeesh showed that there was a
premium for investing in high momentum stocks.<ref>{{Cite journal|last=Jegadeesh|
first=Narasimhan|date=July 1990|title=Evidence of Predictable Behavior of Security
Returns|url=http://finance.martinsewell.com/stylized-facts/dependence/
Jegadeesh1990.pdf|journal=The Journal of Finance|volume=45|issue=3|pages=881–898|
doi=10.1111/j.1540-6261.1990.tb05110.x}}</ref><ref>{{Cite journal |last1=Jegadeesh
|first1=Narasimhan |last2=Titman |first2=Sheridan |date=1993 |title=Returns to
Buying Winners and Selling Losers: Implications for Stock Market Efficiency |
journal=The Journal of Finance |volume=48 |issue=1 |pages=65–91 |
citeseerx=10.1.1.597.6528 |doi=10.1111/j.1540-6261.1993.tb04702.x |jstor=2328882 |
s2cid=13713547}}</ref> In 2015 Fama and French added profitability and investment
as two additional factors in their five-factor asset pricing model.<ref>{{Cite
journal |last1=Fama |first1=Eugene F. |last2=French |first2=Kenneth R. |date=2015-
04-01 |title=A five-factor asset pricing model
|url=https://www.sciencedirect.com/science/article/pii/S0304405X14002323 |
journal=Journal of Financial Economics |volume=116 |issue=1 |pages=1–22 |
doi=10.1016/j.jfineco.2014.10.010 |issn=0304-405X}}</ref> Profitability is also
referred to as the [[Quality investing|quality factor]].<ref>{{Cite journal |
last=Novy-Marx |first=Robert |date=2013-04-01 |title=The other side of value: The
gross profitability premium
|url=https://www.sciencedirect.com/science/article/pii/S0304405X13000044 |
journal=Journal of Financial Economics |volume=108 |issue=1 |pages=1–28 |
doi=10.1016/j.jfineco.2013.01.003 |issn=0304-405X}}</ref> Other significant factors
that have been identified are leverage, liquidity and volatility.<ref
name=":0">{{Cite journal |last1=Blitz |first1=David |last2=van Vliet |first2=Pim |
date=2007 |title=The Volatility Effect: Lower Risk Without Lower Return |
url=https://papers.ssrn.com/abstract=980865 |journal=Journal of Portfolio
Management |language=en |doi=10.3905/jpm.2007.698039 |ssrn=980865|
s2cid=154015248 }}</ref><ref>{{Cite journal |last1=Bollen |first1=Nicolas |
last2=Fisher |first2=Gregg |date=2012-07-03 |title=Send in the Clones? Hedge Fund
Replication Using Futures Contracts |journal=The Journal of Alternative Investments
|volume=16 |issue=2 |pages=80–95 |doi=10.3905/jai.2013.16.2.080 |s2cid=219222562 |
ssrn=2102593}}</ref><ref>{{Cite journal |last1=Pástor |first1=Ľ |last2=Stambaugh |
first2=R.F. |date=2003 |title=Liquidity risk and expected stock returns |
journal=Journal of Political Economy |volume=111 |issue=3 |pages=642–685|
doi=10.1086/374184 }}</ref>
==Value factor==
The most well-known factor is [[value investing]], which can be defined primarily
as the difference between intrinsic or fundamental value and the market value. The
opportunity to capitalize on the value factor arises from the fact that when stocks
suffer weakness in their fundamentals, leading the market to overreact and
undervalue them significantly relative to their current earnings. A systematic
quantitative value factor investing strategy strategically purchases these
undervalued stocks and maintains the position until the market adjusts its
pessimistic outlook.<ref>{{Cite web |title=Factors from Scratch {{!}} O'Shaughnessy
Asset Management |url=https://osam.com/Commentary/factors-from-scratch |access-
date=2018-09-06 |website=osam.com}}</ref> Value can be assessed using various
metrics, including the [[P/B ratio|P/E ratio]], [[P/B ratio]], [[Free cash flow to
equity|P/S ratio]], and [[dividend yield]].

==Low-volatility factor==
[[Low-volatility investing]] is a strategy that involves acquiring stocks or
securities with low volatility while avoiding those with high volatility,
exploiting the low-volatility anomaly. The [[low-volatility anomaly]] was
identified in the early 1970s but gained popularity after the 2008 global financial
crisis. Different studies demonstrate its effectiveness over extended periods.<ref
name=":0" /> Despite widespread practical use, academic enthusiasm varies, and
notably, the factor is not incorporated into the Fama-French five-factor model.
Low-volatility tends to reduce losses in bear markets, while often lagging during
bull markets, necessitating a full business cycle for comprehensive evaluation.

==Momentum factor==
[[Momentum investing]] involves buying stocks or securities with high returns over
the past three to twelve months and selling those with poor returns over the same
period. Despite its established phenomenon, there's no consensus on its
explanation, posing challenges to the efficient market hypothesis and random walk
hypothesis. Due to the higher turnover and no clear risk-based explanation the
factor is not incorporated into the Fama-French five-factor model. Seasonal
effects, like the January effect, may contribute to the success of momentum
investing.

==See also==
* [[Style investing]]
* [[Value investing]]
* [[Low-volatility investing]]
* [[Momentum investing]]
* [[Quality investing]]
* [[Fama–French three-factor model]]
* [[Carhart four-factor model]]

==References==
{{reflist}}

[[Category:Investment]]