Factor Investing 1 – Introduction

Factor Investing 1 – Introduction

Today’s post is the first in a series on factor investing, otherwise known as smart beta.

MSCI

We have to start somewhere, and I’ve chosen to start with MSCI (the index firm), for two reasons:

  1. They make dozens (though not all) of their papers on factor investing available to the public.
  2. I attended a webinar on factor investing last week, and someone from MSCI was on the panel.
What is factor investing?

Factor investing, in practical terms, is the use of a rule other than market-cap weighting (as used by normal index funds) to allocate money within a pooled investment fund.

Factor premia represent exposure to systematic sources of risk that have historically earned a long-term premium.

Passive Active Spectrum

Passive Active Spectrum

The big debate is whether factor investing is an active or a passive strategy.

  • The alternative name of smart beta (which seems to have picked up negative connotations over the years since it was introduced) doesn’t really help us much here.

Factors are also sometimes known as tilts.

Active vs Passive

Active vs Passive

My personal opinion is that there’s no such thing as a truly passive investor.

  • We’re all making choices about where to park our money that deviate from the “universe of money” (some of which is likely to be unavailable to us in any case).

Market-cap weighted index investing, which seems to have swallowed the term “passive investing”, is just one way amongst many of approaching this.

  • And although it has advantages in terms of cheapness, simplicity and transparency, it’s definitely not the best approach in terms of maximising returns.

For example, equally-weighted (EW) indexes usually outperform market-cap weighted ones.

  • EQ is a form of Small Cap investing since their will be a greater allocation to smaller firms than in a market-cap weighted index.

Of course, passive has another sense, that of the amount of effort required from the investor.

  • On those terms, factor funds are passive, unlike a small cap stock portfolio.
What are the factors?

US FF

US FF

A factor can be thought of as any characteristic relating a group of securities that is important in explaining their returns and risk.

Factor investing comes out of CAPM and the various Fama and French (FF) factor models.

Global FF

Global FF

FF identified three factors back in the 1990s:

  • the market (beta)
  • size (small cap), and
  • value (low price to book).

Later on they added US MSCI

US MSCI

MSCI currently have six factors:

  1. Value
  2. Small Size
  3. Global MSCI

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