Multifactor Asset Pricing: Theory and Practice
Investment portfolios are often evaluated by their risk-adjusted returns based on a single factor asset pricing model, the Capital Asset Pricing Model (Sharpe, 1964). Portfolios with excess returns relative to their riskiness have positive alpha which is viewed as favorable. Investors may be willing to pay high fees to a skilled active manager who has delivered alpha. Financial economics has evolved rapidly since Sharpe (1964); we have learned a lot. Today, asset pricing is viewed through the lens of multiple pricing factors (Fama & French, 1993, 2015). When portfolios are evaluated through the multifactor lens it is much more difficult to find evidence of skilled managers – most managers are simply delivering noisy (and expensive) exposure to priced factors. The corollary is that rather than paying high fees to an active manager, investors seeking higher expected returns may seek systematic, low-cost exposure to these same priced factors.