Eugene Fama and Kenneth French introduced the first multi-factor model to the investing world over 20 years ago. But it’s been only recently that “factor investing” has really come into vogue. This we believe to be due to a confluence of three developments:
• Advances in technology and data collection that allow for more accurate measurements of factor contributions to risk and return
• Asset/wealth managers’ drive to enhance the returns on nominally “passive” or “index” investments as a way to differentiate offerings from pure index products, but still retain low prices and academic “efficient market” legitimacy
• Growing use by active managers as a component or complement to existing analytical tools in order to better manage risk and understand sources of return
In its simplest form, factor analysis seeks to identify and quantify the contribution that different criteria may have on performance. Many of the factors used are the same ones that fundamental managers analyze as part of their investment processes, such as ratios that measure the financial well-being of a company. Other factors may include quantitative measures or broad macroeconomic data. Models can be as simple or as complex as the user desires.
The growing popularity of multi-factor models and factor investing has created new market opportunities. But there are challenges as well. For example, marketers must explain an extremely complex and sophisticated methodology in a manner that is easily understood and meaningful to the end investor. They must further demonstrate how this new approach better meets investors’ needs and manages risk in the post financial crisis world. Those who successfully meet this communication challenge, however, have the potential to gain significant market advantage over their less transparent competitors and may be able to carve out a much bigger share of this “new” approach to investing.