It’s all too easy to venture down the road of factor investing without taking time to ask an obvious question – what actually is a factor? Well, one way to approach this, is perhaps to consider some of the features factors ought to have. In our view, they need at least four such characteristics, which we will try to describe within one of the key diagrams in finance – the Capital Market Line (CML).

Figure One shows a sketch of the CML, the straight line that links an investment in a risk-free asset with that of the market and therefore illustrates the critical tradeoff between reward and risk that all investors must face. Of course, there’s a vast amount of financial theory within it, but, for our purposes, we just want to focus on points A, B, C, and D to discuss the first two of our four “required” factor features.

We start by noting that point A is unlikely not a good place to be on this diagram. This point represents an investment (individual asset, asset class, strategy etc.) that has higher risk, and lower expected return than the market (labeled in the diagram as the “Market Portfolio” and often proxied by a large cap equity index). In other words Point A has a lower Sharpe ratio than the broad market. Because the slope of the line linking the risk free rate and the Market Portfolio is the Sharpe Ratio of the market, then it’s apparent that a line linking the risk free rate and Point A would be less steep (lower Sharpe Ratio). So bottom line in our opinion, try to avoid investments similar to those represented by Point A.

How about Point B? Well, Point B appears to be, based on risk vs return, a better investment to Point A. Note that, for the same level of risk as A, it offers a higher expected return. There is no reason not to prefer it (assuming just a mild degree of rationality – that most investors prefer the potential for more vs. less return for the same risk). However, Point B still has the same Sharpe Ratio as the market (it trades exactly on the CML). That means it is not generating any alpha. An investor could replicate Point B by simply taking a leveraged position in the Market Portfolio.

**That’s our first key factor feature – there must be an expectation of a higher Sharpe Ratio (higher risk-adjusted return) than the market (alpha generation).**

Turning to Point C next, and things are starting to look interesting. Note that although Point C has a lower expected return than B (and indeed than A), crucially, it trades above the CML. That means that for its given level of risk, it has a higher expected return than A and B (or, put another way, it has a higher Sharpe Ratio, and is alpha generative). The one concern with C is that it offers such a small pickup in return compared to the same risk point on the CML that it raises questions about its economic significance (we deliberately plotted it above the line, but not by much). It’s possible that the additional complexity and/or transaction costs involved in moving from the CML to Point C could erode its advantages.

**That leads to our second key factor feature – higher risk-adjusted returns must be economically meaningful.**

So, as you may have expected, we are naturally led toward Point D which is, in our view, the most attractive point on the diagram. Point D is starting to represent something close to what we expect from factors – it has a meaningfully higher risk-adjusted return than the market. However, there are still two hurdles that Point D needs to jump.

First, there has to be an expectation that it will continue to trade above the CML month- after- month, and year- after- year. In other words, the alpha an investment, such as the one represented by Point D has to offer, must be statistically significant over time. It can’t just be a transient feature that will quickly be arbitraged away.

**That leads to our third key factor feature – higher risk-adjusted returns must be persistent across time.**

Finally, we believe that there has to be a rationale or intuition behind every factor, even if it’s ultimately close to impossible to prove as the reason for its existence. Let us explain. Imagine a strategy that advocated only owning stocks that begins with vowels. We would argue that, even if it had offered meaningful, and even statistically significant alpha, an investor ought to be very wary of a strategy that has no plausible explanation. Mandating that such an explanation exists will afford the investor some protection against investing in a strategy that has been lucrative to date, by chance (even tests for statistical significance can’t fully eliminate the role of chance).

**That leads to our fourth key factor feature – even meaningful, statistically significant, alpha needs an intuitive economic rationale.**

**Bottom Line**

Different investors may define factors differently. We believe a good starting point is to apply the “four key factor features” model – higher risk-adjusted returns over the long run, that are economically meaningful, persistent, and have intuitive economic rationales.

*For more on Smart Beta ETFs, visit the Smart Beta Channel home page.*