This page is dedicated to the academic and practical research on factor investing, especially the longest studied and exploited factor–the value investing factor–from three star research teams: 1. Eugene Fama and Ken French (F&F); 2. Josef Lakonishok, Andrei Shleifer, and Robert Vishny (LSV); and 3. Applied Quantitative Research (AQR). The teams reached the same conclusion: Value investing strategies consistently outperform glamour strategies in the long run.
That is where the similarity ends because their explanations for value’s outperformance varies. F&F believed value (and small cap, the first two factors that they researched) outperformed because it was compensation for additional risk.
Two years after F&F published their paper, LSV flatly rejected F&F’s conclusion:
This article provides evidence that value strategies yield higher returns because these strategies exploit the suboptimal behavior of the typical investor and not because these strategies are fundamentally riskier.
AQR has been somewhat agnostic, although I have heard AQR’s founder, Cliff Asness, say that he does not think the value premium is attributable entirely to risk. (Update: April 2015: In a new white paper, Asness, et al. write “…our best guess is that both risk and behavioral causes are at work (in the value premium).” Whether any of the factors outperform because of risk or because institutional constraints and behavioral biases lead to mispricing, AQR doesn’t seem to care because both explanations could lead to the conclusion that the long-run, market-beating returns will continue. If attitudes toward risk do not change, neither will the value premium. If human behavior and institutional constraints do not change, neither will the value premium.
(Other evidence that the value premium is unrelated to risk can be found here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1840551)
Finally, the quality factor is the latest factor studied (beginning in the 2010s) and incorporated in quantitative investing models. Quality is estimated in different ways–F Scores, gross margins, etc.–but the essence is the same. Companies that perform better in these metrics outperform the market. Why? Well, persistently high gross margins are an indication that a business has strong competitive advantages; what Warren Buffett likes to call “wide moats” and wide-moat firms are not always given full credit for those advantages.
Each team exploited its research outside of academia by attempting to “beat the market,” at least on a risk-adjusted basis, by investing other people’s money for a fee. F&F joined Dimensional Fund Advisers (DFA) and helped it grow its assets under management (AUM) to over $380 billion, while LSV launched their own firm and grew AUM to over $80 billion.
In the early 1990s at the University of Chicago, Cliff Asness chose Eugene Fama to be advisor for his dissertation on the momentum factor. Asness started Goldman Sachs’s Quantitative Investment Group before creating AQR and growing it to well over $100 billion in AUM.
AQR and DFA attempt to exploit all four factors–Value, Small Cap, Quality, and Momentum. AQR attempts to invest directly in momentum, while DFA attempts to indirectly incorporate that information through trading in their main strategies.
The research found on this page and “The Superinvestors” page launched many value-investing careers, including mine when I first came across the F&F research while studying for the CFA II exam in 1995.
The original F&F and LSV papers follow as does a recent compelling paper by Asness et al. on the momentum factor. I previously included a short video from DFA in which several employees explain how the 1992 paper by F&F introduced DFA to the world of value investing, but DFA has removed that video from their site.
LSV:Lakonishok Shleifer and Vishny’s Contrarian Investment Extrapolation and Risk Journal of Finance 1994
AQR: Asness and Moskowitz Working Paper on 10 Momentum Myths 5-9-14