While academics and financial practitioners have subjected risk factor investing to decades of study and have published countless articles, single and universally prescribed forms for individual factors do not yet exist.
Although illustrative of the broader concept, this paper, Risk Factors Are Not Generic, focuses on two important but seemingly overlooked sources of differentiation across risk factors: factor definition and factor construction.
Factor definition describes the observable asset characteristics (e.g., “book value” and “earnings yield”) utilized to formulate a particular factor (e.g., equity value). Factor construction describes the design and implementation to compose a specific factor’s definition. Even for a well-known and market-assimilated factor like equity value, seemingly subtle differences in the precise definition and construction of the factor can create meaningful divergences in factor performance.
Practical Implications for Risk Factor Investing
For better or worse, there is still no single “correct” or optimal definition and construction of a given factor—equity value, commodity momentum, or another. Researchers armed with historical data can only look to identify which formulation has performed better or more consistently along certain dimensions during particular periods. Rarely (if ever) will they find that one definition or one construction dominated along all dimensions during all periods. Instead, when determining how to incorporate risk factors into a broader portfolio, investors must pass judgment not only on definition and construction, but also—and more importantly—on the process of researching, and then selecting among or combining the options.
Passing judgment on a manager’s process is not a challenge peculiar to risk factor investing. Thoughtful asset allocators recognize that evaluating strategies simply by their historical track records or (worse) their descriptions does not guarantee future performance.
The challenge peculiar to risk factor investing is that too many asset allocators and investment managers believe that risk factors are generic, and that asset allocators have the luxury of picking from a set of (nearly) identical formulations. Some of the alternative names for risk factor investing, such as “smart beta,” reinforce this illusion. Unlike “beta,” risk factor investing requires numerous, influential, active decisions by investment managers. Thoughtful asset allocators will need to invest as much effort in assessing these active decisions as they do when evaluating all of their active managers.