[Tell me your research] Raman Uppal Factor Investing Insights
Raman Uppal, eminent professor of Finance at EDHEC Business School co-chaired the “New Methods for the Cross Section of Returns” Conference with the Fama-Miller Research Center at Chicago Booth and the Review of Financial Studies on September 28. The researcher told us more about, on the one hand, the creation of the conference and, on the other, the prominence, the trends and the impact of the topic addressed - Factor Investing – in the Financial industry. An area in which EDHEC has developed a “leadership” since the creation of EDHEC-Risk Institute and the research spin-off Scientific Beta.
R.U: "EDHEC is a leader in the area of factor investing. There is a large quantity of research on factor investing that has been undertaken at Scientific Beta and EDHEC Risk Institute. Besides, Scientific Beta, with more than USD 30bn in assets replicating indices that are representative of this factor-investing research, has acquired significant credibility in the industry. Consistent with this research focus, some of my research is also in the area of factor investing. It is clear that being able to strengthen our position in this research area is a first-order challenge for the EDHEC group."
Idea of the conference
R.U: "Given the strong interest in the area of factor investing, both in the academic community and amongst practitioners, I discussed with several researchers working in this area the possibility of organizing a conference on this theme. All the people working in the area of factor investing thought that this was an excellent idea. In particular, Michael Weber, Professor of Finance at the University of Chicago, expressed great enthusiasm for the conference; he was supported also by Lubos Pastor, Co-Director of the Fama-Miller Center for Research in Finance at the University of Chicago. Andrew Karolyi and Stijn Van Nieuwerburgh, editors of The Review of Financial Studies also thought that this was a great idea. When I discussed the possibility of this conference with Abraham Lioui and Christophe Roquilly at EDHEC, both were very supportive. So, quite frankly, the idea of organizing the conference was a "no-brainer" because it seemed a most opportune time to have a conference on the topic of factor investing and there was broad support for it."
Trends in the area of factor investing
R.U: The idea of factor investing originated in the late 1960s with the work of William Sharpe, whose Capital Asset Pricing Model suggested that only one factor, the aggregate stock market, is required for efficient investment. This insight was the motivation for the development of ETFs (Exchange Traded Funds) in the 1980s.
"But, follow-up empirical work showed that the market factor was not very good at explaining the cross-section of stock returns; that is, why different stocks had different returns. The work of Fama and French in the 1990s demonstrated that perhaps one needed three or four factors to explain the cross section of stock returns.
But, the search for better models of the cross section of stock returns continued. Fama and French extended their model to allow for five or six factors. Other people also developed models with multiple factors. Consistent with this insight, Scientific Beta enables investors to choose multifactor strategies.
The search for new factors was pursued very aggressively by researchers. As a result, over the last few years, the research community identified hundreds of potential factors. So, much of the recent work, and many of the papers presented at the conference, are now trying to understand whether we really need hundreds of factors, or if only a handful of factors will suffice to explain the cross section of stock returns."
Your recent contribution
R.U: "My own research in this area, which is undertaken with Alberto Martin-Utrera (Lancaster University Management School), Victor DeMiguel (London Business School), and Javier Nogales (Universidad Carlos III de Madrid), studies how many factors are needed to explain the cross section of stock returns when investors care not just about expected returns but also about the risk of their portfolios and the transaction costs that have to be paid for trading the stocks underlying these factors. Our key insight is to show that the presence of transaction costs increases the number of factors in which one would like to invest, contrary to what one may have expected. The intuition for this is that if one trades a larger number of factors, each based on the same set of underlying factors, it is possible to reduce the volume of trading by netting out trades across factors, and hence, to reduce transaction costs."
How are the academic findings challenging for the Finance industry?
R.U: "These academic finding are forcing the finance industry to reevaluate their financial offerings. I feel that the focus on trading costs and the usefulness of multifactor investing in this context is an argument that emphasizes the idea that multifactor investing allows one to benefit from long-term diversification across factors."