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One of the central concepts in finance is that returns above the risk-free rate are compensation for exposure to risks. Stocks have earned a premium above the risk-free asset because they expose their owners to their underlying risk factors. The capital asset pricing model (CAPM) can be thought of as the first theory of risk factors. According to the CAPM, the expected excess return on a risky asset is equal to the beta of the asset times the risk premium on the market portfolio. When asset returns are normally distributed, the CAPM correctly identifies the only risk factor to be the return on the market portfolio, and the measure of exposure of each stock to this factor to be its beta. By relaxing the assumptions of the CAPM, academic and industry researchers have extended the model, leading them to develop a long list of risk factors.18 Even though there is no consensus about the number of risk factors in financial markets, it is well established that the market portfolio is not the only risk factor in the market. The risk premiums earned by stocks and other traditional assets are indeed a combination of various risk premiums.

Our discussion of factor investing begins with three important observations detailed by Ang (2014):

1. Factors matter, not assets: The factors behind the assets matter, not the assets themselves. Assets are nothing more than means for accessing factors.

2. Assets are bundles of factors: Most asset classes expose investors to a set of risk factors; therefore, the risk premium offered by an asset class represents a package of risk premiums offered by factor exposures. Exposures of assets and risk premiums to factors can be used to estimate the risk premium that an asset should provide.

3. Different investors should focus on different risk factors: Asset owners differ in terms of time horizons, risk tolerances, objectives, and liabilities that should be funded. These differences require careful examination of factor exposures of a portfolio in order to ensure that the asset owners do not have too much or too little exposure to some factors.

If we consider the risk premium earned by each asset class to be a function of exposures to several risk factors, then several important questions arise:

What is a risk factor?

Do all risk factors offer the same risk premium?

How do these risk premiums behave through various stages of a business cycle?

Are all risk factors investable?

How does one perform risk allocation based on risk factors?

Do allocations based on risk factors outperform allocations based on asset classes?

These questions are addressed in the next six sections.