For decades, investment portfolios were constructed from a combination of market cap weighted index funds and active funds. Cap weighted index funds can provide a basis for investors to acquire the market portfolio in a simple, transparent, and cost-effective manner. By contrast, active funds promise potentially higher returns, albeit at the cost of greater complexity and higher fees.
In recent years, institutional investors have employed a new approach to portfolio construction: factor-based investing. This increasingly popular approach lies between passive and active investing, allowing investors to target specific risk factors (return drivers) as well as market beta. These strategies use a transparent, systematic, rules-based method at relatively low costs. This enables investors to implement active strategies while remaining under the passive umbrella.
In this paper, the origins and evolution of factor-based investing are examined. The theories underpinning factor-based investing, developed from the Capital Asset Pricing Model (CAPM) and its multifactor extensions are discussed. The economic intuition behind factor performance is analyzed, along with its implementation. Finally, likely innovations and future product strategies are briefly considered.
Factor risks are the driving force of assets’ risk premia. One of the first financial theories to model asset returns as a function of factor risks was the linear CAPM. This model was formulated in the 1960s and stated that there is only one factor, the market factor, driving the returns of assets. Moreover, the CAPM stipulates that the return of an asset is the sum of systematic return and specific return, as shown in equation one.
The CAPM models the systematic return as a function of the beta that measures the sensitivity of assets’ returns to the market return. An asset’s beta is given by: