In the world of factor investing, not all factors are created equal. While hundreds of "factors" have been discovered in academic research, only a handful consistently drive stock returns over time. So, how do you separate meaningful factors from statistical noise?
To identify a “good factor”, professional investors and quants use three core tests:
Economic Rationale
Persistence and Pervasiveness
Investability
In this blog, we’ll break down these tests and explain how they help determine which factors are worth your attention.
1. Economic Rationale: Does the Factor Make Sense?
A good factor must have a clear reason why it works—not just a backtested track record.
- Behavioral Explanation:
Many factors exist because investors behave irrationally. For example, momentum works because investors often underreact to news, leading to price trends. - Risk-Based Explanation:
Some factors, like value or size, offer higher returns because they carry higher perceived risk. Investors demand a premium for holding "cheap" or small-cap stocks.
Why It Matters:
Without a sound rationale, a factor might simply be the result of data mining—an anomaly that won’t repeat in the future.
2. Persistence and Pervasiveness: Does It Work Across Time and Markets?
A good factor must demonstrate long-term persistence across different time periods, regions, and asset classes.
- Time Horizon:
Does the factor hold up over decades, including bull and bear markets? For example, value investing has a 100-year history of generating excess returns, despite periods of underperformance. - Geographies:
A robust factor like momentum works not just in U.S. stocks, but also in Indian, European, and emerging markets. - Asset Classes:
Some factors (e.g., momentum) also appear in commodities, bonds, and currencies, proving their universality.
Why It Matters:
If a factor only works in a specific market or for a short window, it’s likely a fluke.
3. Investability: Can You Actually Use It?
Even the most powerful factor is useless if it’s not practical to invest in.
- Liquidity:
Are the stocks selected by the factor liquid enough for trading?
For example, small-cap stocks might show impressive returns in theory but come with high slippage and impact costs. - Transaction Costs:
Does the factor require frequent rebalancing? Momentum, for example, needs careful execution to ensure costs don’t eat into returns. - Transparency:
Are the rules simple enough to implement without complex, proprietary data? Factors like value and quality pass this test easily.
Why It Matters:
Factors must not only deliver alpha but also be executable for both institutional and retail investors.
4. The 3-Test Framework in Action
Consider Quality as a Factor:
- Economic Rationale: High-quality companies (strong ROE, low debt) are less likely to default and deliver sustainable earnings.
- Persistence: Studies show quality stocks outperform in multiple regions and timeframes.
- Investability: It’s easy to measure quality using widely available data.
Now compare this to an obscure factor like “Super Bowl Indicator” (markets rise if an NFC team wins)—it fails all three tests.
5. Key Takeaways
- A good factor is backed by logic, is proven over time, and is practical to implement.
- Classic factors like value, momentum, quality, size, and low volatility pass these tests, which is why they remain the building blocks of quant and smart beta strategies.
