Practical Applications of Factor Investing: From Theory to Practice

Abstract

In Factor Investing: From Theory to Practice, from the Winter 2022 issue of The Journal of Beta Investment Strategies, Tarun Gupta, Jay Raol, and Viorel Roscovan (all of Invesco) present a simple but rigorous evidence-based framework for testing and accepting factors as valid drivers of risks and returns. They find that value, momentum, quality, and low volatility are valid factors but that the size factor is questionable. Their methodology for validating factors comprises four elements: 1) economic theory, 2) robust risk and return evidence, 3) cross-asset and cross-region validation, and 4) implementability. The authors stress that investors should consider only factors that are implementable in practice. Incorporating real-world constraints into implementability tests allows investors to identify the factors that deliver attractive risk–return trade-offs after accounting for transaction costs and investment constraints.