In an article on ETF.com, BAM Alliance research director Larry Swedroe discussed issues related to factor investing, the potential problems with research around it, and the criteria he believes must be met to suggest that a factor will endure.
According to Swedroe, a factor should first meet the following two conditions:
- Be a unique source of risk and return not explained by other well-documented factors already used in asset pricing models;
- Have delivered a premium in the form of higher returns.
Once those criteria are met, Swedroe offers the following list of other necessary criteria:
- Persistence: the factor holds across long periods of time and “different economic regimes.”
- Pervasive: the factor “holds across countries, regions, sectors and, where applicable, asset classes.”
- Robust: the factor is not dependent on a single formation that might have been the result of data mining.
- Investable: the factor stands not just on paper “but also after considering actual implementation issues, such as trading costs.”
- Intuitive: “There are logical, risk-based or behavioral-based explanations for the premium and why it should continue to exist.”
Swedroe concludes by saying that all factors, including those that meet the aforementioned criteria, “have experienced long periods of underperformance. So, before investing, be sure that you believe strongly in the rationale behind the factor and the reasons why you trust it will persist in the long run. Without this strong belief, it is unlikely that you will be able to maintain discipline during the inevitable long periods of underperformance. And discipline is one of the keys to being a successful investor.”