Facts and Fantasies About Factor Investing

112 Pages Posted: 16 Nov 2014 Last revised: 28 Nov 2014

Zélia Cazalet

Lyxor Asset Management

Thierry Roncalli

Amundi Asset Management; University of Evry

Date Written: October 31, 2014

Abstract

The capital asset pricing model (CAPM) developed by Sharpe (1964) is the starting point for the arbitrage pricing theory (APT). It uses a single risk factor to model the risk premium of an asset class. However, the CAPM has been the subject of important research, which has highlighted numerous empirical contradictions. Based on the APT theory proposed by Ross (1976), Fama and French (1992) and Carhart (1997) introduce other common factors models to capture new risk premia. For instance, they consequently define equity risk factors, such as market, value, size and momentum. In recent years, a new framework based on this literature has emerged to define strategic asset allocation. Similarly, index providers and asset managers now offer the opportunity to invest in these risk factors through factor indexes and mutual funds. These two approaches led to a new paradigm called 'factor investing' (Ang, 2014). Factor investing seems to solve some of the portfolio management issues that emerged in the past, in particular for long-term investors. However, some questions arise, especially with the number of risk factors growing over the last few years (Cochrane, 2011). What is a risk factor? Are all risk factors well-rewarded? What is their level of stability and robustness? How should we allocate between them? The main purpose of this paper is to understand and analyze the factor investing approach in order to answer these questions.

Keywords: Factor investing, risk premium, CAPM, risk factor model, anomaly, size, value, momentum, low beta, quality, volatility, idiosyncratic risk, liquidity, carry, mutual funds, hedge funds, alternative beta, strategic asset allocation

JEL Classification: C50, C60, G11

Suggested Citation

Cazalet, Zélia and Roncalli, Thierry, Facts and Fantasies About Factor Investing (October 31, 2014). Available at SSRN: https://ssrn.com/abstract=2524547 or http://dx.doi.org/10.2139/ssrn.2524547

Zélia Cazalet

Lyxor Asset Management ( email )

Paris
France

Thierry Roncalli (Contact Author)

Amundi Asset Management ( email )

90 Boulevard Pasteur
Paris, 75015
France

University of Evry ( email )

Boulevard Francois Mitterrand
F-91025 Evry Cedex
France

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