Valuations Matter in Factor Strategies

It’s a familiar investment conundrum: when a strategy outperforms and more investors pile in, it can get more expensive and therefore be less likely to outperform going forward. This is discussed as it relates specifically to factor investing in a recent Morningstar article.

Alex Bryan, CFA, director of passive strategies research (North America) for Morningstar, poses the question: “What if the apparent performance edge is not sustainable and investors are just relapsing into counterproductive performance-chasing?” He offers support for related research results published by Rob Arnott and his colleagues at Research Affiliates. Arnott, says Bryan, “argues that valuations matter, and it is necessary to account for the valuations of each factor to properly set expectations for future returns.”

Using data from 1967 through March 2016, the Research Affiliates team discovered an inverse relationship between valuations and future performance for certain factors. For example, they found that as value stocks become cheaper relative to growth stocks, for example, they were more likely to outperform during the subsequent five-year period. This was confirmed relative to small-cap, illiquidity, and gross-profitability factors as well, and was more pronounced in low-turnover portfolios.

However, Bryan argued, while valuations matter, “investors probably shouldn’t use valuation spreads to time factor exposures, unless those spreads are extreme.”