STREET DOGS

From Chicago Booth Review, Factors 101 T he original factor — or the forerunner of factor analysis

— is, in a sense, the capital asset pricing model (CAPM). Largely developed by Stanford’s William F Sharpe, who was awarded the Nobel Memorial Prize in Economic Sciences in 1990, the CAPM posits that investors are paid for both the time value of their money and the risk they assume in holding an asset.

The formula is not reliably predictive. It generates an expected return on assets based in part on the beta of a security, or its covariance with the market … some finance professionals refer to the CAPM as “the one-factor model”, where market beta is the sole explanatory factor of expected returns.

In 1992, expanding on the CAPM, Chicago Booth’s Eugene F Fama and Dartmouth’s Kenneth R French published a three-factor model, identifying two more things that generate returns: size and value. They observed that smallcap companies outperformed large-cap ones over time, and companies with low price-to-book ratios outperformed companies with higher price-to-book ratios.

In 1997, Mark Carhart published an article that suggested momentum as a fourth factor.

Between this point and 2016, researchers developed another 300 factors. Even Fama and French contributed to the growing pile of factors, coming out with research in which they suggest two more explanatory factors in stock returns: profitability (highearnings-growth companies get higher returns) and investment (companies with high total asset growth typically generate lowerthan-average returns).

Competition within academia is fuelling a rush to discover or develop new factors, says Fama. “You have thousands of academics in this area, all of whom need to come up with papers to publish, so the door is open wide.”