By Jack Forehand, CFA (@practicalquant)
Factor strategies have grown exponentially in the past decade. Almost every major asset manager now offers their variation of things like value, momentum, quality, and low volatility, and each of them has their case as to why their approach is better than the others. But at their core, all these strategies rely on one basic principle – that if you invest using factors, you will earn an excess return over the market over time.
I have been running factor strategies for over fifteen years now and am a big believer in them. But that process has also taught me a lot about what derails them in the real world. As is the case with many things in life, taking the theory of factor investing and putting it into practice can be very challenging. There are many misconceptions about how these strategies work, and what they can and can’t do.
Here are the biggest misconceptions I have seen about factor strategies.
[1] That they are less risky than the market – There are two major explanations for why factor strategies work over time. One of those is that they earn excess returns as compensation for taking on additional risk. If you are a believer in the efficient market hypothesis, then risk explains all the outperformance of factor models and if you aren’t, you may believe that there is also a behavioral explanation, but either way, there is no getting around the fact that factors (with the exception of low volatility) earn greater returns by taking greater risk. But many investors expect the opposite.
This is particularly common with value. Investors think that if you only pay 5 times earnings for a company, you are taking less risk than if you pay 15 or 20. But that isn’t usually the case. Value stocks typically trade at a steep discount because something is wrong with their business, and a significant risk exists that they will not be able to overcome whatever that problem is. On average, the market tends to overestimate this risk and value stocks have outperformed because of it, but the ride along the way to get that outperformance will likely be a very bumpy one.
[2] That three- and five-year periods are the best for judging performance – One of the most difficult things for investors to understand about factor-based strategies is how long you have to hold them to put the odds in your favor of generating the desired results. Investors continue to want to judge strategies over three- and five-year periods, but the data suggests that underperformance over those time frames is fairly common. In fact, underperformance over ten years is also more common than you probably think it is. Take a look at this chart from Larry Swedroe that looks at the percentage of time each major factor underperforms over selected periods.
Any investor who follows factor strategies will likely see regular periods during their investing lifetimes where they underperform over three and five-year time frames. They will also likely see periods of 10+ years where their strategy struggles. The ability to weather these periods is crucial to generating the excess returns that factors can produce.
[3] That the biggest key to performance is the strategy itself
There have been investors who have been successful running value strategies (although that may be hard to believe right now). There have also been investors who have succeeded using momentum. Low volatility has also been a historically successful approach. Investors tend to believe that finding the exact right factor or the exact right implementation of it is the most important driver of success. But it isn’t. The most important driver of success is the investor themselves and their ability to adhere to the strategy. This point goes hand in hand with the previous one because there are going to be periods where a strategy struggles. The return lost to poor investor behavior during those periods is likely to dwarf the impact of things like whether you use the PE ratio of the Price/Sales over the long-term. Building a strategy you can stick with is far better than building the perfect strategy.
[4] That the past is always predictive of the future
I am a big believer in base rates. I think you have a much better chance of predicting future outcomes based on what has happened in the past than trying to do your own forecasting. Most of the time, relying on the past to identify the factors that work will lead to successful results. But it is important to acknowledge that there is never complete certainty in investing. With complete certainty there is no risk, and with no risk there is no excess return. By choosing to follow a factor strategy, you are assuming a risk that the factor you follow will stop working. We could potentially be seeing that now with Price/Book (although it will be a long time before we can say that definitively). That doesn’t mean that the risk that something that has worked for decades will stop working is high. It just means that it exists and should be acknowledged.
[5] That they are free from human emotion
One of the biggest advantages of a factor-based approach is eliminating human emotion from the investment decision making process. But it is important to understand that it will never go away completely. Behind every factor strategy is a person who built it. And they are subject to all of the same biases that the investors in their strategies are. They have to decide which factors to use. They have to decide when and how to change them. And they are prone to making mistakes in those decisions. The good managers will implement disciplined systems to mitigate this, but it can never be eradicated. Completely eliminating emotion from the investment process is a dream more than a reality.
[6] That you should expect to match academic results in the real world
I have learned a lot from academic research. I have used it extensively in the development of the models we run. But it is also important to understand that the real world introduces a variety of complexities that will lead to different results. For example, most academic papers that run factor portfolios use a long-short approach where they invest in the stocks with the highest factor scores and short those with the lowest. In the real world, most funds only use the long side of the equation. In addition, transaction costs are very difficult to estimate in an academic environment. This can be an issue for high turnover strategies like momentum and lead to lower returns in the real world than in testing. Finally, many academic studies include smaller stocks that are very hard to invest in for factor funds running hundreds of millions of dollars. If those small stocks were a big part of the return in the tests, then you can expect lower returns in the real world.
None of this is meant to indicate that I am not a big believer in factor investing. My belief is just as strong today as it was a decade ago (although it has certainly gotten harder). My goal here is just to make the point that it is very important to understand what you are getting before you adopt any investment strategy. These misconceptions are all ones that I have seen regularly in speaking with investors over the years. If you understand them going in, you will have a much better chance to be successful as a factor investor.
