Abundance or overwhelm?

The proliferation of factors over the past three decades has led rise to the concept of the ‘factor zoo’, a phrase describing the vast array of factors detailed by academics and investment practitioners alike.

The concept of factor investing has been around since the 1960s when William Sharpe created the Capital Asset Pricing Model (CAPM), a concept that suggested individual stocks are sensitive to market movements. 

However, it became evident that market beta could not entirely explain movements in prices which led Eugene Fama and Kenneth French to create their three-factor model of market, size and style. Other factors including value, momentum, low volatility and quality were subsequently introduced as potential ways to outperform the wider market over the long term. 

Publication bias

These have become the most common factors adopted by investors in the bid to improve the risk-return profile of their portfolios.

However, the popularity of factor investing led to a surge in academic literature which attempted to identify new factors that could deliver positive results from a risk-return perspective.

Highlighting this, there have been 400 investment factors published in top academic journals, according to research conducted by Campbell Harvey and Yan Liu.

Examples of factors published in journals since 2010 include firm hiring rate, profitability, information intensity and political sensitivity. 

This surge in factors is driven by demand to be published. Academics are more likely to be published if they produce positive results that support the factor in question while negative results are often ignored. 

As a result, factors can be impacted by data mining and subjective backtests that look to prove they have long-term investment value. 

Trust and robustness

“The rate of factor production in the academic research is out of control,” Harvey warned. “Surely, many of them are false. We explore the incentives that lead to factor mining and explore reasons why many of the factors are simply lucky findings.

“The backtested results published in academic outlets are routinely cited to support commercial products. As a consequence, investors develop exaggerated expectations based on inflated backtested results and are then disappointed by the live trading experience.” 

The proliferation has led to a lack of consensus on which factors are truly robust and driven trust issues in the investment community about the usefulness of incorporating various factors within portfolios. 

Investors must always be aware of being too reliant on academic research when incorporating factors within portfolios. Sticking to the traditional factors is an important first step to ensuring portfolios remain robust.