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Foundations In Factors

Historically, style factors have been shown to deliver superior risk-adjusted returns to passive capitalization weighted indexes and more persistent performance than traditional active management, making them a compelling alternative for investors.




Although the efficacy of style factors conflicts with modern financial theory, they have been successfully employed for more than 40 years to improve upon passive capitalization weighted equity portfolios. Empirical studies have repeatedly shown style factors outperform capitalization-weighted benchmarks across most global markets and deliver more consistent performance than traditional active management. However, like all investment strategies, style factors are not without potential drawbacks. They are very susceptible to prolonged periods of poor relative performance. This cyclicality is problematic given that investors commonly evaluate strategies on a three-to-five year horizon and style factors are prone to underperform over such short holding periods, ultimately leading to divestment. Nonetheless, there are ways to improve the likelihood that investors will realize the benefits of style factors.

History and Evolution of Style Factors

William Sharpe introduced the first factor model in 1964: the Capital Asset Pricing Model (CAPM). It only included a single factor (beta) and was quite straightforward:

Ε(Ri) = Rf + βi(E(Rm) – Rf)

Or commonly,

Ε(Ri) – Rf = βi(E(Rm) – Rf)


  • Ε(Ri) is the expected return of asset i
  • Rf is the risk-free rate of interest
  • E(Rm) is the expected return of the aggregate market portfolio
  • βi is the sensitivity of asset i to the expected excess return of the aggregate market portfolio over the risk-free rate of interest(1)

(1) From this point forward, excess return refers to the return earned above the risk-free rate of interest

Sharpe’s model states we should only be compensated for market beta, so if portfolios reliably generate high (low) excess returns, it must be solely as a result of higher (lower) beta. However, there is plenty of evidence to suggest otherwise. In 1992 Eugene Fama and Kenneth French introduced a three-factor model that had much better success in explaining historic stock returns than the CAPM. Fama and French’s model rejected market beta as the only systematic risk factor and addressed the more prevalent CAPM issues by including factors for size and value(2). In 1997 Carhart extended the Fama and French model to include a fourth factor - momentum. Carhart’s model also explained the three most prevalent equity market anomalies in one succinct package – value, size and momentum.

Implications for Investors

Similar to capitalization weighted investing, style factors offer a systematic, diversified, and transparent source of return, but with the added benefit of higher Sharpe Ratios. Furthermore, style factors offer the ability to outperform the market, but in a more reliable and cost-effective manner than traditional active investing. This topic was thoroughly explored by Carhart (1997) through a study of more than 1800 mutual funds from 1962 to 1992. Initially he found strong persistence in active returns, but after the returns were subsequently adjusted for style factors(3), the persistence disappeared. More importantly, after adjusting for style factors, alpha was found to be negative, indicating that manager “skill” actually decreased returns on average.

The Perils of Factor Cyclicality

Although the benefits of style factor investing are enticing to investors, they should not be viewed as a free lunch. There are three deterrents that collectively create a high hurdle for style factor adoption:

1. Style factors are prone to sustained periods of underperformance

2. Investors commonly evaluate strategies on a three-to-five year horizon

3. Investors tend to resent losses more than they value gains of an equal amount

These considerations suggest style factor investors will be inclined to abandon the strategy at some point during the holding period, potentially to their detriment. Whether an investor chooses to stay invested (or divest) is not simply a matter of relative performance, though it is undoubtedly of chief concern. There are also behavioral factors at play such as Prospect Theory, which states that investors resent losses more than they value gains of an equal amount (Kahneman and Tversky, 1979).

Diversify Within and Across Factors

Diversification is an effective means of mitigating style factor cyclicality, but it is only one of several tools available. A number of considerations must be taken into account in order to deliver the benefits of style factors in an acceptable manner. Exogenous systematic risks often accompany style factor strategies and can create significant tracking errors. Examples of these systematic risks include fundamental factors such as industries, countries, and macroeconomic risks such as growth and inflation. Furthermore, style factors are not perfectly independent from one another and the relationships among them vary over time. An effective multi-factor strategy must account for this to prevent the style factor premium from becoming diluted. While factor cyclicality cannot be completely eliminated, factor strategies that account for these considerations exhibit downturns that are significantly shorter and shallower than naïve alternatives.

(2) The authors used book to price to represent value
(3) Analysis was done with the Fama-French-Carhart model including size, value, momentum, and beta


Style factors have been shown to historically deliver superior risk-adjusted returns than passive capitalization weighted indexes and more persistent performance than traditional active management, making them a compelling alternative for investors. The benefits of style factors come with the cost of cyclicality, exposing investors to the risk of sustained underperformance.

Style factor cyclicality may be mitigated by employing multi-dimensional factor definitions and diversifying across factors, in addition to other methods of reducing risk without sacrificing return. Through intelligent factor design and implementation, drawdowns can be made less severe, which makes it easier for investors to stay the course. Given the potential benefits style factors afford, we recommend investors seek out portfolios designed explicitly to improve the investor experience and avoid divestment.

IMPORTANT INFORMATION. The information contained herein is intended for use with current or prospective clients of Northern Trust Investments, Inc. The information is not intended for distribution or use by any person in any jurisdiction where such distribution would be contrary to local law or regulation. Northern Trust and its affiliates may have positions in and may effect transactions in the markets, contracts and related investments different than described in this information. This information is obtained from sources believed to be reliable, and its accuracy and completeness are not guaranteed. Information does not constitute a recommendation of any investment strategy, is not intended as investment advice and does not take into account all the circumstances of each investor.

This report is provided for informational purposes only and is not intended to be, and should not be construed as, an offer, solicitation or recommendation with respect to any transaction and should not be treated as legal advice, investment advice or tax advice. Recipients should not rely upon this information as a substitute for obtaining specific legal or tax advice from their own professional legal or tax advisors. References to specific securities and their issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. Indices and trademarks are the property of their respective owners. Information is subject to change based on market or other conditions.

Investing involves risk- no investment strategy or risk management technique can guarantee returns or eliminate risk in any market environment.

Forward-looking statements and assumptions are Northern Trust’s current estimates or expectations of future events or future results based upon proprietary research and should not be construed as an estimate or promise of results that a portfolio may achieve. Actual results could differ materially from the results indicated by this information.

Past performance is no guarantee of future results. Performance returns and the principal value of an investment will fluctuate. Performance returns contained herein are subject to revision by Northern Trust. Comparative indices shown are provided as an indication of the performance of a particular segment of the capital markets and/or alternative strategies in general. Index performance returns do not reflect any management fees, transaction costs or expenses. It is not possible to invest directly in any index. Gross performance returns contained herein include reinvestment of dividends and other earnings, transaction costs, and all fees and expenses other than investment management fees, unless indicated otherwise.

Northern Trust Asset Management is composed of Northern Trust Investments, Inc., Northern Trust Global Investments Limited, Northern Trust Fund Managers (Ireland) Limited, Northern Trust Global Investments Japan, K.K., NT Global Advisors, Inc., 50 South Capital Advisors, LLC, and personnel of The Northern Trust Company of Hong Kong Limited and The Northern Trust Company.

© 2019 Northern Trust Corporation. Head Office: 50 South La Salle Street, Chicago, Illinois 60603 U.S.A.

Mike Hunstad portrait

Michael Hunstad, Ph.D.

Chief Investment Officer – Global Equities
Michael Hunstad is chief investment officer for global equities at Northern Trust Asset Management with responsibility for all quantitative equity research, strategist, and quantitative equity portfolio management activities.