As Professor John Cochrane observed, the literature on investment factors now fills a veritable “factor zoo” with hundreds of options. How do investors select from among this huge array of possibilities?
Noah Beck, Jason Hsu, Vitali Kalesnik and Helge Kostka, authors of the paper “Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs,” which appears in the September/October 2016 issue of CFA Institute Financial Analysts Journal, attempt to help investors navigate their way through this factor zoo by determining which exhibits are worth visiting.
The authors take a similar approach to the one my co-author, Andrew Berkin, and I took in our book, “Your Complete Guide to Factor-Based Investing.” For a factor to be considered worthy of investment, we established the following criteria. It must be:
- Persistent – It holds across long periods of time and different economic regimes.
- Pervasive – It holds across countries, regions, sectors and even asset classes.
- Robust – It holds for various definitions (e.g., there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales).
- Investable – It holds up not just on paper, but after considering actual implementation issues, such as trading costs.
- Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.
Beck, Hsu, Kalesnik and Kostka used the following criteria:
- Factors should be grounded in a long and deep academic literature. They write: “A factor strategy that does not attract follow-on research usually means that the factor has not survived academic scrutiny.”
- Factors should be robust across various definitions. They shouldn’t be dependent on one very specific formulation (such as price-to-book as a value metric) but fail to work if other related versions are tested.
- Trading costs matter (which is similar to what my co-author and I called “investable”).
- Factors should be robust across geographies.
Using these criteria, Beck, Hsu, Kalesnik and Kostka identified a small group of popular equity factors: illiquidity, low beta, value, momentum, size and quality. The authors then formed portfolios on the basis of factor characteristics to evaluate a factor’s robustness. Following is a summary of their findings.