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.