What, exactly, is a factor?

When it comes to building factor models, there are many definitions of a factor. But what is the right one?

In this paper, we set out to create a set of factor-mimicking portfolios (FMPs) that represent different ways style researchers and portfolio managers might construct a factor portfolio. The FMPs are meant to represent exposure to a chosen factor, but they have varying degrees of ‘purity’ of that exposure, with some allowing other bets, such as industry and other risk-model style factors.

Factor investing key takeaways:   

• The underlying investment universe, frequency of rebalancing, presence or absence of exposures to other factors and the ability to short are all important drivers of factor returns 
• Beware how the factor portfolio used to generate returns is exposed to the factor – it may not be providing the expected exposure
• Only a pure factor is appropriate for factor-based attribution 
• Choose a factor that best represents your specific investment process and be mindful of definitions that muddle numerous factors together