By Jack Forehand (@practicalquant) —  

Below are some of our favorite things we read or listened to this week and one important lesson we took from each of them.

This Week’s Topics

• Why Factor Investing is So Hard
• Industry Concentration in Factor Investing
• Reframing the Pain of Underperformance as a Positive

Article: What to do When an Investment Strategy Performs Poorly

Lesson: Successful implementation of factor investing strategies requires sitting through extended periods of underperformance

This is an excellent piece by Larry Swedroe.

Investors hate underperformance. If investment managers underperform for six months, they start to get questions about the efficacy of their strategy. If they underperform for a year, those      questions get louder. After three years, clients will start to head out the door. After five, there won’t be many left.

That is why most investors have difficulty following factor-based approaches. They try to match long-term strategies with a short-term time horizon. They assume if a strategy doesn’t work over a year or three years, then that means it doesn’t work long-term. But the opposite is true.

Take a look at the chart below from this article.

These are all the major factors that have been proven to work over the long-term. Even over periods as long as ten years, they all show underperformance at times. We are currently in a period where value has underperformed for a long time, but this chart illustrates why that is perfectly normal. The value factor has underperformed in 14% of ten-year periods. If you follow value, you are very likely to experience one of these ten year-periods at some point. The ability to stay the course during that type of extended underperformance is required to benefit from the outperformance of the factor. Most people can’t do that and that is why factor investing is much harder than many think.

Podcast: Cliff Asness – The Past, The Present & Future of Quant

Lesson: How factor strategies handle industry concentration is crucial to understanding them

This is only a minor point they covered within a great discussion on all aspects of factor investing, but it is a very important one to understand.

There are two ways to handle industry concentration in factor portfolios. The first is you can let your factor strategies determine your industry allocation (usually subject to some upper limits). In other words, if your system likes lots of financial stocks, then you overweight Financials in your portfolio. The second way to is keep your industry allocation similar to your benchmark and to select the best stocks within each industry. This is the way Cliff explains that AQR does it on this podcast.

There is no right or wrong answer. There are some of the best firms in the industry on either side of the debate. Letting the strategy determine the industry allocation works if you think that many firms passing your approach within the same industry at the same time makes the industry more attractive. But it also introduces more risk and tracking error because you will look more different than your benchmark. The second approach works if you think factors are better at picking stocks than industries.

The important thing is that you understand what you are getting when you invest in factor portfolios because the two approaches can produce very different outcomes.

Interview: Five Questions: Value Investing With Wes Gray

Lesson: Reframing pain as a positive can help you adhere to an investment strategy in tough times.

This is an interview we did with Wes Gray of Alpha Architect. Wes had so many great insights about factor investing and investing in general, but this one stuck with me.

In response to the recent struggles of value investing, Wes said the following

“Regardless, “value is dead” articles are fine by me and I actually love them. The more perceived – and actual experienced pain – the better for long-duration capital compounders, in expectation.”

What Wes is saying here is that investors in value (and other factors as well) get paid for experiencing pain. If value worked all the time, everyone would follow it, and it would eventually stop working. So the pain you experience in following these strategies is the price of admission to get their long-term outperformance. If you look at it that way, you will actually welcome the underperformance because you will see that pain as something that increases the eventual premium you will get. This is obviously very difficult to do in practice, but adopting that mindset would certainly help investors maximize their long-term returns.

Photo: Copyright: donskarpo / 123RF Stock Photo