The equity factor approach coming out of the work of Fama, Ross, Sharpe is largely based on a rational expectations / utility maximisation framework in economics which sees no role for animal spirits or irrational behaviour. Now since the 2008 recession, there has been quite a lot of push back against this psychologically naive view of economic behaviour, yet none of that has made its way into academic factor work. In that factor work, despite the fact that equity markets are micro-efficient yet macro-inefficient (to quote Samuelson) leads modellers to produce bottom up explanations of the power and value of factors. Factors, in this sense, are aggregate phenomena, arrived at through linear summations of atomic firms; these factors are then judged based on various perceived qualities of those aggregates - the market factor, small size, momentum, profitability, quality, term, carry - being persistence, breadth, robustness, investability, economically plausible, etc.
I like to think of that model as a model where the motivating power of the model resides solely with leaf firms in a tree of equity relations. But those leaf points are not the only possible entry points. Motive power could strike at higher levels, and trickle down or across.
Take Shiller's work on the cyclically adjusted PE ratio. From it, it is clear that there's more volatility in the equity market than changes in fundamentals would suggest. To me, in the factor world, this suggests we re-partition the equity risk premium in a different way. We perhaps model 'confidence' as a time-varying fraction of the equity risk premium and model factors in the remnants. Perhaps we would see momentum vanish. We ought also to partition history into slices of a universal business cycle, and learn to model conditional factors.
Most factor research has been academic research, yet investment firms have much more data. Those firms need factor architecture which is built around the possibility of multiple parallel factor models. Why? Because they will always want to have a reference implementation which agrees with the outside world (the Fama French model, the Bloomberg model, the Barra model). The degree to which they match is a validation step on the firm's architecture. This ought to bring the confidence level of the firm internally concerning the specific quality of their in house model to a higher level.
I also think the basic CAPM model market factor ought to be revised with respect to in play m&a firms. Perhaps via a joint m&a/CAPM/factors model where the weighting of usually towards the factors side, and drifting towards the m&a side. This would make the equity market risk premium to be the sum of those two disjoint premia. There is, after all, a completely different set of risks accruing to an in-play m&a target (and acquirer) versus one which is exposed to the arrival of new information in the usual way.
I think a model of information arrival is a way to unite these two. When a target is in play, then it becomes sensitised to a different realm of information. It is being informed by the skill of the purchaser's assessment plus the regulatory climate. A target in a very well respected deal with a low probability of deal break is a very unusual thing - it represents a firm whose future value at some horizon is known with much higher certainty than other firms' stock values at that time horizon.
This raises a general point about the meaning of 'market beta' in a multi factor world. As you add more factors, the meaning of market beta and differs. A CAPM single factor market premium is not in general the same as the market premium associated with a three factor model.
I think factor models will also rapidly become essential tools for risk managers, as important in time as the greeks are for the volatility space. In addition to managing trader specific risk limits, the risk team ought also be on the lookout for firm-wide risks, cross-cutting currents which may not be visible to any one trader, or even necessarily to the busy CIO. Equity factor models would help greatly in this respect. So they should be the common property of the firm, not a trader tool.
