The development of core factor investing

 

First there was the CAPM factor which failed as researchers found that low beta stocks had higher returns and high beta stocks had lower returns than what would be expected with the CAPM model. It is a good theoretical model but its ability to explain cross-sectional returns is limited.

This led to the development of the Fama-French three factor model which included market risk, size (SMB) and value (HML) factors. This was a significant improvement and changed the way investors thought about risk.

From this framework Carhart added the momentum factor (UMD) or (MOM) which created the four-factor model. This now caused a significant amount of finance confusion. How can past performance predict or tell is something about relative returns" There is acceptance hat momentum is present in all assets classes and that is a fundamental risk factor albeit there is a still a view that this is a behavioral problem that should not exist. 

However, there was a desire to find more factors based on economic theories which were developed through the papers of Zhang et al. who found what were called q-factors which included operating profitability, ROE, and investment or a real investment factor or asset growth. 

Fama and French extended their 3-factor model to include operating profitability robust mins weak (RMW) which is measured by revenues COGS - interest expense SGA scaled by book value, and investment, conservative minus aggressive or CMA which is just asset growth scaled by total assets. This led to the quality factor as a key addition or for some a better interpretation of value.  

Since these core factor developments, there has been a zoo of factors to describe many risk premia. Many of these factors have not stood the test of time, but it shows that the search for return drivers is a dynamic and ongoing process. However, the core work of market risk, size, value, momentum, and quality are now the key factors for any discussion of equity returns.