Causal factor investing has emerged as an important new paradigm in finance research and investment management in recent years. Numerous academics have published influential papers on ssrn.com that establish a theoretical foundation for factor based investing. These research papers argue that factors like value, momentum and quality have a root cause and behave systematically because they are tied to underlying risk factors in the economy and human behavior. Understanding the economic rationale behind factors can lead to more robust and rational investment processes compared to traditional factor investing approaches. This article will summarize several key ssrn papers on causal factor investing and extract the core academic insights around implementing factor strategies grounded in financial theory.
Fama and French five factor model establishes broad factors explain stock returns
The seminal 2015 Journal of Financial Economics paper by Nobel laureates Eugene Fama and Ken French establishes a five factor model that explains stock returns. Their research finds that market, size, value, profitability and investment factors drive differences in average returns across stocks. This model provides a framework for causal factor investing, as it shows these factors consistently predict stock performance and are tied to risk. Other researchers have built on Fama and French’s model to argue that factors have fundamental economic drivers like distress and quality that justify investing in them.
Hou, Xue and Zhang trace momentum to delayed overreaction to news
The prominent 2015 Review of Financial Studies paper by Hou, Xue and Zhang provides a risk based explanation for momentum investing. They argue momentum is caused by delayed overreaction – stocks underreact to news in the short term and then experience return continuation as the news diffuses across investors. This gradual information diffusion creates a systematic pattern that momentum strategies can exploit. Their model demonstrates momentum is compensation for bearing delayed overreaction risk.
Value investing compensates for risks linked to financial distress
Combining insights from Fama and French plus Hou, Xue and Zhang, the value factor can be understood as exposure to financial distress risk. The 2014 critical review paper by Fama and French highlights how high book-to-market (value) stocks tend to have persistently low profitability and high leverage. As a result, value stocks carry higher risk of financial distress. The value premium compensates investors for bearing this risk. This establishes an economic logic for value investing.
Quality investing rewards exposure to profitable, growing firms
The 2017 Journal of Portfolio Management article by Asness, Frazzini and Pedersen explicates a risk foundation for quality investing. High quality stocks with metrics like high profitability and low investment tend to be growing firms with sustainable competitive advantages. Meanwhile, low quality stocks are often structurally challenged. This bifurcation means quality stocks have higher valuations to reflect growth opportunities. Quality investing involves compensating exposure to solid, robust businesses.
Causal factor investing guided by financial theory offers a principled approach for tapping into systematic return premia linked to underlying economic risks. Ssrn papers provide rigorous academic evidence on the fundamental drivers of factors like value, momentum and quality. Anchoring factor strategies in these root causes can yield more robust investment solutions.