Factors represent investment characteristics that help explain the behavior of a security and may be used in combination with smart beta techniques to deliver efficient exposures to desired factors.
Investors frequently view smart beta through the lens of risk and return drivers, or factors, an academic term that is growing in adoption among practitioners. Increasingly, the two terms are used interchangeably despite core differences between the two. Factors represent investment characteristics that help explain the behavior of a security, whereas smart beta, which breaks the link between price and weight in a portfolio, can be combined with factor return premiums to deliver efficient exposures, net of transaction costs, to investors.
The growth in popularity of factor investing has created some confusion. The market has been flooded with an egregious number of presumed “factors” backed by positive backtests, although many may be the sole result of data mining. We believe it is more important now than ever to understand the risk preferences and/or behavioral anomalies driving factor premiums and to be skeptical of newly discovered factors.