Factor Investing: The Truth Has Many Shades

Scientific investing unfortunately isn’t that scientific.

April 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The data from Professor French has laid the foundation for factor investing
  • However, over time factor portfolio construction grew complex and with many nuances
  • Returns may look more or less attractive, which makes a weak foundation

INTRODUCTION

When I was growing up one of my favourite TV shows was The X-Files, which followed the lives of FBI Special Agents Fox Mulder (David Duchovny) and Dana Scully (Gillian Anderson) exploring paranormal events. For our younger readers, it was about aliens that had infiltrated human civilization, especially the military and security complex of the U.S. government.

Almost every episode ended with the tagline “The Truth Is Out There”. Today, I am spending a considerable amount of time conducting quantitative research and finishing my days thinking the same, “the truth is out there”, somewhere.

Unfortunately, investing is as much an art as it is a science. For example, today there is no standard definition for cheap stocks when pursuing factor investing. For some investors, it will simply be the price-to-book ratio of stocks, while others combine several metrics. Which one is right?

It is interesting to note that a significant amount of the foundational literature of factor investing is based on data provided by Professor Kenneth R. French, which is freely available on his website. Almost every research article, including many of our own, and marketing pitches in this space feature his data.

The factor returns have been replicated by other researchers, which highlights a robust methodology. It can be considered almost like the truth on factor investing and we are very grateful for it (try Finominal’s Alpha Analyzer for a factor exposure analysis).

But even this truth has several shades to it, which we will explore in this research note.

THE COMPLEXITY OF CALCULATING FACTOR RETURNS

There are many nuances when calculating factor returns, where the primary considerations are transaction costs, the universe of stocks, and the portfolio construction.

First, tra