Scientific Beta

Factor investing has never been as popular as it is today. However, with the propagation of this type of investment approach, the equity space is becoming increasingly saturated with more and more factors that are ever more removed from academically-grounded research. This paper discusses factor definitions used in investment products and analytic tools offered to investors and contrasts them with the standard academic factors. It also outlines why the methodologies used in practice pose a high risk of ending up with irrelevant factors.

Factor investing has never been as popular as it is today. However, with the propagation of this type of investment approach, the equity space is becoming increasingly saturated with more and more factors that are ever more removed from academically-grounded research. In a bid to maintain their apparent competitive advantage and to show that they are still delivering alpha, commercial index providers and asset managers have respectively embarked on a factor finding process that has resulted in the discovery of tens, hundreds or even thousands of factors. However, proprietary factor definitions and analytic toolkits produce non-standard factors, and this can lead to unintended exposures and misunderstandings surrounding the associated risk exposures. The further away they are from academically-validated research, the more spurious and redundant proprietary factor definitions may be. Investors can choose to rely on standard factors that have survived the scrutiny of countless empirical studies and have been independently replicated and validated. Alternatively, they can choose to forego this free due diligence and take on the risk of selecting a provider-specific factor definition, which is somewhat similar to taking on the risk of selecting an active manager. Scientific Beta’s research is underpinned by academic principles and aims to remind the investment community of the original promise of factor investing.