Foundations of Factor Investing

Factor investing has become a widely discussed part of today’s investment canon. In this paper, we
discuss the rationale for factor investing and how indexes can be constructed to reflect factor returns in
cost-effective and transparent ways.  


A factor can be thought of as any characteristic relating a group of securities that is important in
explaining their return and risk.  A large body of academic research highlights that long term equity
portfolio performance can be explained by factors.  This research has been prevalent for over 40 years;
Barra (now an MSCI company) for instance has undertaken the research of factors since the 1970s.   


Certain factors have historically earned a long-term risk premium and represent exposure to systematic
sources of risk.  Factor investing is the investment process that aims to harvest these risk premia
through exposure to factors.  We currently identify six equity risk premia factors: Value, Low Size, Low
Volatility, High Yield, Quality and Momentum. They are grounded in academic research and have solid
explanations as to why they historically have provided a premium.


MSCI has created a family of factor indexes that are designed to reflect the performance of those six
equity risk premia factors.  In turn, indexation has provided a powerful way for investors to access
factors in cost-effective and transparent ways.  Factor allocations can be implemented passively using
factor indexes, which may bring potential cost savings to institutional investors.  Furthermore, factor
indexes bring transparency to factor allocations, which helps alleviate the well-known problem of
manager style drift and has positive implications for risk management.


We note that factor indexes should not be viewed as replacements for market cap indexes.  Market
capitalization weighted indexes represent both the opportunity set of investors as well as their
aggregate holdings.  Market cap weighted indexes are also the only reference for a truly passive, macro
consistent, buy and hold investment strategy.  They aim to capture the long term equity risk premium
with structurally low turnover, very high trading liquidity and extremely large investment capacity.  In
contrast, factor indexes rebalance away from a neutral market cap starting point. As such, they
represent the result of an active view or decision. Investors must form their own belief about what
explains the historical premium and whether it is likely to persist.  


Factor returns have also been highly cyclical. These systematic factors have been sensitive to macro-
economic and market forces and have underperformed the overall market for long periods of time.
However, they have not all reacted to the same drivers and, hence, any one of them can have low
correlations relative to other factors. Diversification across factors has historically reduced the length of
these periods of underperformance.  Thus, the MSCI Factor Indexes provide building blocks that allow
investors to assemble multi-factor allocations based on their preferences for performance and risk, their
investment beliefs on individual factors, and their investability constraints.