Equity Markets, Valuation, and Analysis

CHAPTER 16Factor Investing

Aaron Filbeck, CFA, CAIA, CIPM

Associate Director of Content Development, CAIA Association

INTRODUCTION

This chapter is an overview of factor investing. A factor is a measurement of systematic risk used to explain returns for most diversified portfolios. Although not new to the academic literature, factor investing has become popular in mainstream practice to target specific risk drivers and expected returns.

Many traditional active managers are directly or indirectly factor investors through their stock selection. By simply isolating the underlying factors in an active manager's portfolio, investors can often partially or fully explain that manager's performance. Thus, factors are a useful tool for active management benchmarking and/or full replication.

This chapter has three major sections. The first section offers a brief history of factor investing, starting with the capital asset pricing model (CAPM), which is a single-factor model. The second section provides a more in-depth look at some other most prominent factors besides the market, including value, size, and momentum, as well as some more recent discoveries such as low volatility and quality/profitability. The third section introduces some portfolio management considerations in practice, including multi-factor portfolio construction and active management benchmarking.

Other chapters in this book explore additional investment strategies such as fundamental active and quantitative equity investing. ...