A recent article in Advisor Perspectives by BAM Alliance’s Larry Swedroe offers a list of criteria investors should consider when choosing a factor-based strategy.
According to the article, “The factor must show evidence of being a unique/independent source of risk that has generated a premium that is:”
- Persistent across time and economic regimes;
- Pervasive across geographic areas, sectors and asset classes;
- Robust in that it holds across various metrics;
- Investable in that it works not just on paper but also after considering issues such as trading costs;
- Intuitive—”There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.”
Swedroe argues, “among the ‘zoo’ of equity factors documented in the academic literature, only a handful pass all the tests: market beta, size, value, momentum and profitability/quality,” adding that, “it is particularly important to consider transaction costs (investability) because market impact costs may substantially erode a strategy’s expected excess returns.”
The article cites two other studies that evaluate the effects of trading costs on returns and concludes that implementation costs of some strategies can exceed a fund’s expense ratio, “making it critical that investors consider not only the factor exposure provided by a fund and its expense ratio, but also the fund’s construction rules and implementation strategies.”
