Factor Investing: Evidence Based Insights

Factor Investing: Evidence Based Insights

I will be talking on the Factor Investing panel at the upcoming Evidence-Based Investing Conference in Dana Point, CA next Sunday –Tuesday. I am excited for the opportunity to chat, and figured I would highlight a few thoughts we have on the topic going into the event.

First, what is “evidence based investing?” What does that even mean?

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If we read a index factsheet, review a long-term live track record, or read an academic finance paper, are we now an evidence-based investor? No.

To me, evidence based investing means reviewing all the relevant research on a topic, viewing this body of research as a whole, understanding the economic/human underpinnings of the finding, and then making an informed decision that is as objective as possible. Achieving the title of being an “evidence based investor” sounds easy, but the reality is that this is incredibly difficult. This difficulty is only magnified by the sheer amount of information and (so-called) research being distributed into the marketplace. To solve this information overload problem investors often get complacent and rely on a single firm’s research (or research group) to inform their opinion on all matters. This approach will likely turn you into a faith based investor, not an evidence based investor (see here for a piece on the subject). And when it comes to factor investing, we often see well-meaning investors, who want to be evidence-based investors, quickly devolving into faith based investors who are no longer critically reviewing and assessing the available research.

With factor investing there are a few topics worth discussing:

  1. Factor Premium Premiums — Are they here to stay?
  2. Factor Portfolio Construction – Does it matter?
  3. Factor Investing Funds – What are you actually buying?

Factor Investing Premiums - Are they here to stay?

Are factor premiums here to stay or have they been arbitraged away?

This is a common question we are asked. As advocates of factor-investing(1), how does one respond to the countless articles citing the evidence that factor/active funds are losing to the passive index?

Our response is not satisfying: active (factor) investing is simple, but not easy.

As we have highlighted in the past (I recommend you read the entire article), active factor portfolios are notoriously challenging for investors. Consider value investing, the most well known factor approaches. Value investing has had numerous periods of underperformance, especially during the Internet Bubble. Using Ken French’s data, we examined just how painful it was to be a value investor in the late ’90s.

We examine the returns from 1/1/1994-12/31/1999 for a Value portfolio (High B/M quintile, VW returns), Growth portfolio (Low B/M quintile, VW returns), Risk-Free return (90-day T-Bills), and SP500 total return. Results are shown in Figure 1 below. All returns are total returns and include the reinvestment of distributions (e.g., dividends). Results are gross of fees.(2)

Figure 1: Summary Statistics (1994-1999)

Factor Investing

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Talk about a bad stretch! Looking at the annual returns (shown in Figure 2), value investing lost almost every year to the market!

Figure 2: Annual Returns

Factor Investing

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

What would their hypothetical returns look like in the long run? As you can see below in Figure 3, value quickly recovers and outperforms the entire time period thereafter. Here are the returns to the same portfolios from 1/1/2000 – 12/31/2014, the 15 years following the 5-year underperformance:

Figure 3: Summary Statistics (2000-2014)

Factor Investing

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Sticking with the value strategy, although painful, was richly rewarded with a 4.67%+ edge–per year–over the market benchmark from 2000-2014.

Over the entire cycle, patient, disciplined investors were also rewarded. Here are the results (Figure 4) over the entire time period, measured from 1/1/1994 to 12/31/2014:

Figure 4: Summary Statistics (1994-2014)

Factor Investing

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

Similarly, here is a more recent example using momentum. A common argument is that there are too many supercomputers / Ph.D.s / CFAs in the market so momentum investing is dead. For example, here is a chart on the performance of momentum over the past several decades:(3)

Factor Investing

Is momentum dead? Blue line is a portfolio long winners, the dotted line is a portfolio that is long losers. They are converging, rapidly. The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

The chart certainly follows along with the story — but correlation is not causation. Here is a chart extended back to 1801, which shows that decade long periods of poor relative performance are not uncommon.

Factor Investing

The results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Indexes are unmanaged, do not reflect management or trading fees, and one cannot invest directly in an index. Additional information regarding the construction of these results is available upon request.

If we subscribe to the theory that better technology, smarter people, and more competition are associated with arbitraging away the momentum factor premium, we also need to then explain why momentum went on a 10-year drought following the Civil War.

So why do we highlight how painful factor investing can be?

Any active factor investor should expect the following (in the short-run):

  1. They will lose to the market with a 100% probability over some time period.
  2. They will experience a multi-year relative performance drought.

If factor investing were easy, and allowed everyone to beat the market every year, the premiums would certainly disappear — no pain to invest in factors, but all gain…why not!

Market experience suggests that markets are very competitive so situations of no pain, but all gain are transitory. To the extent that one believes a factor has a premium above and beyond the market return, one needs to identify the pain associated with investing in a factor — and

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