Theory meets practice as three factors—profitability, liquidity, and carry—are added to the factor model to explain expected investment returns. The author also discusses applications of factor-based approaches in portfolio management.
Academic research has led to the expansion of the current factor model—which has traditionally included size, value, and market risk factors—to also incorporate profitability, liquidity, and carry as factors of investment return. Often included in alpha, these factor exposures are better thought of as market betas. Increased transparency into return drivers can help investors achieve better returns at lower costs.
How Is This Article Useful to Practitioners?
The basic idea of factors as building blocks for investment returns is well known. The author discusses the three factors that have recently been added to the factor model: profitability, liquidity, and carry.
Dimensional Fund Advisors recently incorporated profitability as a factor in its equity portfolios based on academic research. And Roger Ibbotson of Zebra Capital Management argues that investors prefer and will pay for liquidity, even though more-liquid portfolios may not carry higher risk. Zebra Capital has incorporated liquidity as a factor in its long-only and long–short hedge funds.
Carry refers to dividend or interest yield in equity and fixed-income securities, respectively. Research shows that lower-yielding securities underperform higher-yielding securities. The concept of carry could, for example, be applied to global currencies.
The author discusses various applications that the newly expanded factor model makes available to firms. Factor-based investing can be applied across asset classes. In addition, investors often pay high active management fees when further scrutiny reveals that the fund’s alpha is simply the result of market-based factor exposures. To address this issue, several existing factor-based funds and exchange-traded funds in the market aim to offer cost-effective market factor exposures. Performance attribution based on the factor model is another potential application.
The author provides a practitioner-oriented introduction to factor-based investing. Important issues not directly addressed here include implementation, performance and benchmarking considerations, and factor exposures for such alternative assets as real assets and private equity.