I treble (maybe the correct term is crave) when I remember factor investing at academic origin. A concept originally discussed in theoretical settings at university finance departments has now become a mainstream investment strategy for both individual investors and large institutions. This piece looks into the pathway of factor investing from its theoretical beginning up to being a mainstream method in the investment industry.

The Academic Foundations

The saga of factor investing starts in academic halls. In the 1960s, William Sharpe laid down some of its basic elements in his Capital Asset Pricing Model (CAPM), giving us how we still talk about the way that assets get priced according to their risk. Trumpeters of this model argued that one factor, market beta was fundamentally responsible for the expected returns of an investment.

Yet as researchers began to look more closely at how markets operated, they realized some of these puzzle pieces could be explained — and potentially foretold— by other factors transcending market risk. The year 1992 brought the seminal paper “The Cross-Section of Expected Stock Returns,” which Eugene Fama and Kenneth French used to roll out their three-factor model in addition to beta, introduced market size (SMB) and price-to-book ratio (HML) as the main return drivers for equities.

This piece detailed the doors to other studies on various determinants that could impact stock market returns. Over the years, momentum quality or crowding and low volatility also appeared to be important return drivers beyond market beta.

From Theory to Practice

A body of academic evidence was building towards the benefits of factor investing, and investors who thought ahead saw it coming. Starting in the 1970s and throughout much of the following decade, firms specializing in quantitative investing began using models rooted deeply in those same academic insights. Dimensional Fund Advisors founded by David Booth and Rex Sinquefield (the disciples of Eugene Fama) is one of the earliest companies in bringing factor-based strategies to market.

But it was not always smooth sailing between academic theory and practical reality. Factor strategies have been around for several decades, but early adopters faced implementation challenges such as high trading costs, poor data availability, and skepticism from traditional investors. However, as technology progressed and markets grew more competitive, these walls started to crumble.

The Rise of Smart Beta

The term “smart beta” arrived in the early 2000s to describe a range of investors seeking both passive and active characteristics from their equity investments. The solution took the form of smart beta products, often ETFs that used a rules-based approach to capturing factor premiums while keeping the transparency and cost-efficiency of index investing.

It was a landmark development in the progression of factor investing. That brought factor-based strategies to the masses, instead of only for the specialized set at large institutions or affluent quant managers. Smart beta product proliferation democratizes factor investing Join Our Newsletters Smart Beta Exchange-Traded Funds (ETFs) contributed to fund flows during the first three-quarters of 2017 Get responsible for ESG ENTER NOW The fac…

Technological Advancements and Big Data

Factor investing has grown even more rapidly after the rise of big data and advancements in computing power. Investors can now (~ 2019) access more data and process it faster, which allows them to pinpoint factors available for analysis with a finer granularity than ever.

Factor investing is also has been increasingly underpinned by machine learning and artificial intelligence. It will foster the discovery of new factors and a better understanding of how to manage factor strategies. They also allow for real-time tampering with factor exposures in response to evolving market conditions.

The Current Landscape

Nowadays, factor investing is one of the key components in many investment forms. Many of my clients are large institutional investors — pension funds, endowments, and the like — who use covering vehicles with factor tilts in their portfolios. Factor-based strategies are available to retail investors via a plethora of ETFs and mutual funds.

This evolution of factor investing has driven more sophisticated implementations. Mutli-factor strategies, which aggregate several factors to potentially improve return and risk outcomes have been experiencing inflows recently. Another line that is being pursued remains the dynamic factor allocation; when over time, a certain exposure to other factors has to change due to market conditions.

Challenges and Future Directions

Factor investing is not a panacea, however. Some critics claim factor premiums are simply arbitraged away because of their popularity. Another debate is also out there, talking about how to define and measure the factors.

So, moving forward factor investing is expected to:

Additional factors are still being identified and prior ones revised.

Advanced multi-factor dynamic allocation strategies.

Growing prevalence of use of alternative data sources and techniques in factor research.

A further refinement would be stronger ESG integration in factor strategies.

Factors more popular in new asset classes and geographies

Conclusion

This evolution from academic theory to mainstream action is a huge transformation in the way we look at and execute investment strategies. What began as a dream in the ivory towers of university finance departments is now an empirical methodology that you can use to construct sound and secure live trading portfolios.

With the evolution of factor investing, it will further gain importance over traditional methods and help investors better achieve their financial goals. For individual investors or those directing one of the world’s largest institutional portfolios, knowledge about factors and how to use them is an integral part of navigating today’s financial markets.