Exploring the merits of five-factor investing: A critical literature review

Abstract

The dynamics of investing in stock markets have changed considerably over the past twenty years. The value and growth investing concept has drawn much attention and continues to dominate portfolio management. Factor investing is an approach that aims at quantifying particular characteristics through matrixes of quality, value, momentum, and growth to improve the returns of a portfolio. Although the three-factor style of investing has gained widespread acceptance, the five-factor continues to be a source of disagreement among academics and industry practitioners. This study aimed to review the merits of five-factor investing critically. A critical literature review was used to review prior literature. The narratives from the literature reveal that the five-factor investing style will result in multiple sources of expected return. Hence, using five factors in portfolio formation has merits and will significantly improve the returns and most likely outperform the market portfolio. Factor premiums have proven to be drivers of asset return. Therefore, market participants and investment managers can intentionally assume additional exposures to deliver superior risk-adjusted returns compared to the market with the five-factor investing style. According to the author's knowledge, this is the first study to objectively analyze the literature on five-factor investing and propose that active managers can earn positive alphas on a risk-adjusted basis through factor exposures.