Much has been made of Factor Investing, and even Vanguard is launching a suite of actively-managed factor ETFs. But even now, with Vanguard offering factor ETFs, there are many investors that only invest passively into an index fund, such as the SP 500 or EAFE index. These investors will cite the numerous studies showing that (on average) active management fails compared to an index fund (there are many studies that highlight this fact).

No arguments with most of those studies and costs clearly matter, but what I would like to highlight in this article is the following:

Even passive index investors are betting on factors.

The idea behind this article is to highlight/review a summary of the literature on factors. Many tend to forget, but the factor with the largest premium is the market factor!(1) Yes, simply investing in the market (i.e. the Sp500) is not really passive — this is a factor-investing bet. Investors in the market-beta asset class are implicitly betting on the equity-premium, which is the outsized returns (in the past) to equities over U.S. Treasury Bills (or cash).(2)

Let’s dig into a few papers that are relevant to this topic.

Factor Returns

The term “factor investing” has come to mean the following to most investors–sorting stocks and bonds on some favorable characteristic(s) that will create a different performance profile than a passive index portfolio. “Smart-beta” funds that sort stocks based on value or momentum are a classic example.(3) Factor investing exists in bonds as well, but is just not discussed as much.

And why do people invest in factors?

Typically, factors are identified when a researcher finds that going long the “good” stocks and selling the “bad” stocks earns a positive risk-adjusted premium. These so-called L/S anomaly portfolios generally have no market beta (at least on a $ amount), and receive a positive return (minus the risk-free rate) from the long/short stock portfolio.(4)

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