CHAPTER 6Factor Investing

6.1. INTRODUCTION

Factor investing is a popular way to gain excess returns on top of market returns in the long run while offering a variety of different investment options. In general, a factor can be thought of as any characteristic relating to a group of securities that is important in explaining their returns. Alternative data sources can be used to devise or anticipate investment factors and hence, in principle, a strategy that can outperform other passive investing schemes, as we will show in the next chapters. In this chapter we will summarize the foundations of factor investing and point to how alternative data can be used to create or enhance factors. Nevertheless, we must say that factor investing is not the only way to make use of alternative data. Indeed, in Chapters 1 and 2, we noted that discretionary investors could also incorporate alternative data in their framework. They could, for example, use one-off surveys to confirm/disconfirm their belief about a position they hold.

6.1.1. The CAPM

Using Markowitz's work as their foundation,1 Treynor (1962), Sharpe (1964), Lintner (1965), and Mossin (1966) all independently developed what is now referred to as the Capital Asset Pricing Model (CAPM).

On top of Markowitz's assumptions, the CAPM further assumes that (1) there exists a risk-free rate at which all investors may lend or borrow an infinite amount, and (2) all investors possess homogeneous views on the expected return and volatility ...

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