Tobias J. Moskowitz describes the debate as behavioral investing vs. a risk-based approach.

Debate continues on underlying reason for factor investing

Academics debate the underlying reason for elements of factor-based investing, including size, value, liquidity and profitability, said Tobias J. Moskowitz, Fama Family professor of finance, University of Chicago, Booth School of Business and research consultant of AQR Capital Management LLC, Greenwich, Conn.

“The debate academics have is whether it's behavioral (investing) phenomenon generating these factors that price assets or risk-based approaches,” Mr. Moskowitz said.

Academics who “come at things from a very market efficiency,” rational perspective take “a risk-based kind of view,” Mr. Moskowitz said. But others, taking a behavioral finance perspective, believe asset mispricing comes from irrational distortions from biases like overconfidence.

“For each one of these factors there is a very healthy debate in academia right now whether it's behavior or risk driving (it),” Mr. Moskowitz said.

“When I talk to the guys at AQR about this (difference), their view is much more agnostic. To be honest, it's not clear they care which of these things it is, so long as there is a good reason for it to be there, and chances are there are elements of both that are true.”

“Do I believe value stocks might be riskier? Yes,” Mr. Moskowitz said. “They might be. Do I believe they might be mispriced? Sometimes. It's certainly possible.”

“In academia, we care a lot about these things because we want to try to understand the true underlying mechanism,” Mr. Moskowitz said. “In practice, I think it's more relevant just that it's there,” that it exists to exploit in investing. “And both of these (theories) give a reason for these to be true.”

Are the points of view for the reason underlying the factors converging?

“You can say that certainly from practice,” Mr. Moskowitz said. “That's less true in academia. In academia, the camps dig in their heels a bit more.”

“But to some like myself, who are relatively agnostic, I sort of see” that convergence.

“To me, the more interesting question is not whether it is one or the other, but can we measure how much of it is one or the other,” Mr. Moskowitz said.

“Because if we know what the risks are, we might think about hedging them or monitoring them” and in a better way.

“But the academic research is not there yet,” Mr. Moskowitz said. “That's big business right now. It's something I spend most of my time thinking about. That progress has just started. There is a lot to do.”

“It's fair to say the evidence is ambiguous.”

This article originally appeared in the April 14, 2014 print issue as, "Debate continues on underlying reason for factor investing".