Factor Investing

Abstract

In recent years, factor investing has seen increased interest in the asset management industry. Also referred to as "Smart Beta" strategies, factor investing incorporates both the characteristics of passive and active strategies: it uses a transparent and systematic approach, but aims at over performing a benchmark. Despite the increased popularity, some questions arise, especially with the number of risk factors growing over the last few years. What is a risk factor? Are all risk factors well-rewarded? Is factor-based allocation superior to asset-based allocation? The main purpose of this thesis is to understand and analyze the factor investing approach in order to answer these questions. The paper is organized as follows. In Chapter I, starting from the concept of Efficient Market Hypothesis I lead the reader trough the mathematics of the Modern Portfolio Theory, the CAPM and multifactor models, which are the building blocks of factor investing. The main factor models and risk factors, such as market, value, size and momentum, are presented, along with the notion of Factor Zoo, in Chapter II. Chapter III shows different Smart Beta strategies and elaborates factor investing vis-a-vis standard asset allocation methods. In Chapter IV I present an empirical application addressing the issue of the alleged superiority or factor-based investing over the more traditional asset-based asset allocation. I conclude in Chapter V with final comments.