Factors (finance)

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A factor is a common characteristic among a group of assets. In the equities market, it could be a particular financial ratio such as the price–earnings (P/E) or the book–price (B/P) ratios.[1] Additional objectives are:

  • Factors frequently are intended to capture some economic intuition. For example, a factor may help understand the prices of assets by reference to their exposure to sources of macroeconomic risk, fundamental characteristics, or basic market behaviour.[note 1]
  • Assets with similar factors (characteristics) tend to behave in similar ways. This attribute is critical to the success of a factor.
  • The factor should be able to differentiate across different markets and samples.
  • The factor should be robust across different time periods.

Factors fall into three categories—macroeconomic influences, cross-sectional characteristics, and statistical factors.[1]

  • Macroeconomic influences are time series that measure observable economic activity. Examples include interest rate levels, gross domestic production, and industrial production.
  • Cross-sectional characteristics are observable asset specifics or firm characteristics. Examples include, dividend yield, book value, and volatility.[note 2]
  • Statistical factors are very different in nature than the above factors as they do not have direct economic interpretation.[2]

Factors are variables used to create a linear model (equation) which describes the returns of a portfolio. In the CAPM model, a portfolio's returns can be described reasonably well based on its exposure to one factor: Beta.

In their three-factor model, Fama and French expand on the CAPM model by adding two factors, HmL and SmB, that fits actual portfolio returns more closely.[3]

Notes

  1. Understanding asset prices is a primary focus for investors.
  2. The Fama-French factors of size and book-to-market have cross-sectional characteristics. Hence, the title of the seminal paper "The Cross-Section of Expected Stock Returns" (1992).

See also

References

  1. 1.0 1.1 Fabozzi, Frank J., and Harry M. Markowitz (eds). "Chapter 11 - Factor-Based Equity Portfolio Construction and Analysis". Equity Valuation and Portfolio Management. John Wiley & Sons. © 2011. ISBN 9780470929919 (accessed September 12, 2012)
  2. Fabozzi, Frank J., and Harry M. Markowitz (eds). "Chapter 13 - Multifactor Equity Risk Models and Their Applications". Equity Valuation and Portfolio Management. John Wiley & Sons. © 2011. ISBN 9780470929919 (accessed September 14, 2012)
  3. How to get Fama-French EAFE Factors, with results, forum discussion by ClosetIndexer, direct link to post.