Foundations of Factor Investing

Factor investing is based on the existence of factors that have earned a premium over long periods, reflect exposure to systematic risk, and are grounded in the academic literature. Early financial theory established that for stocks, exposure to the market was a significant driver of returns (e.g., the CAPM). Later, researchers like Barr Rosenberg, Eugene Fama and Kenneth French extended the CAPM to include certain systematic factors that also were important in explaining returns. Tilts towards these factors such as Value, Low Size, and Momentum historically produced excess long-term returns and there were strong theoretical foundations behind these factors. Until now, passive investing has focused on capturing market beta through market capitalization weighted indexes. The only way institutional investors could get access to factors was through active management. Indexation is opening a new way for factor investing today by allowing investors to access factors through passive vehicles that replicate factor indexes. MSCI Factor Indexes provide access to six solidly grounded factors — Value, Low Size, Low Volatility, High Yield, Quality and Momentum. These indexes have historically earned excess returns over market capitalization weighted indexes and experienced higher Sharpe Ratios. This paper is the first in a three-paper series focusing on factor investing.