CAPM was the first formal asset pricing model. Market beta was its sole factor. With the 1992 publication of their paper, “The Cross-Section of Expected Stock Returns,” Eugene Fama and Kenneth French introduced a new-and-improved three-factor model, adding size and value to market beta as factors that not only provided premiums, but helped further explain the differences in returns of diversified portfolios.
But financial innovation didn’t end there. Today the literature contains more than 600 investment factors, a number so great that John Cochrane called it a “zoo of factors.” However, as my co-author Andrew Berkin and I explain in our recently released book, “Your Complete Guide to Factor-Based Investing,” only a small number of exhibits within this factor zoo are required to explain almost all the differences in returns between diversified portfolios.
To be considered worthy of investment, a factor should not only provide a premium and add explanatory power, it should also meet all of the following criteria. It should 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. For example, there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales.
- Investable: It holds up after considering trading and other costs.
- Intuitive: There are logical risk-based or behavioral-based explanations for the premium, providing a rationale for believing that it should continue to exist.
Factors Aren’t In Lockstep
Academic research has provided investors with a number of factors that meet all the criteria. In addition to market beta, size and value, we can add the equity factors of momentum and profitability/quality. With this knowledge, we can build rules-based portfolios that provide us with systematic exposure to multiple unique factors, each with low correlation to the others.
This low correlation provides diversification benefits, which are important because all factors have experienced long periods of underperformance. However, importantly, they have not all experienced periods of underperformance simultaneously.
A good example of the diversification benefits that factors can provide can be seen by examining value and momentum. From 1964 through 2014, their annual correlation was -0.20. The negative correlation should be expected almost by definition. Consider that when a stock’s price increases, it gains momentum (as long as its price is rising faster than others) while at the same time becoming less “valuey” because it grows more expensive relative to earnings, book value or other fundamental metrics.
Similarly, momentum has been negatively correlated to the size factor. Another example is that profitability/quality has been negatively correlated (-0.27/-0.52) with market beta because investors favor quality in times of uncertainty.