The ignored risks of factor investing
Factor investing is not immune to prolonged periods of underperformance
- The risks of factor investing are understated and the diversification benefits overstated
- Correlations between factors are not constant
- A portfolio invested in multiple factors can still experience drawdowns and periods of underperformanceFactor investing has the potential to improve a portfolio’s long-term risk-adjusted returns
Factor investing, an investment approach that targets specific stock characteristics, such as value or momentum, is growing in popularity and assets under management. Many factor investing strategies are popular for good reason: they are transparent, offer exposure to sources of expected return, frequently have low management costs and, with proper design, low transaction costs.
A typical sales presentation of a factor investing strategy focuses on the (usually backtested) performance characteristics that make historical outperformance look fantastic. Yet, little attention is devoted to the risks of factor investing, which leaves investors underprepared for a bumpy performance ride.
To illustrate some of the risks we have studied six factors that most of these products focus on (and which we view as the most likely to be robust): value, momentum, low beta, size, investment, and profitability.
● The value factor favours stocks that have lower price-to-fundamentals ratios, such as price-to-book, price-to-earnings, and price-to-dividends.
● The momentum factor invests in assets with high returns over a certain formation period, which ranges from six months to a year, and sells short assets with low returns over the same period.
● The low-beta factor favours low-beta stocks.
● The size factor favours small stocks.
● The quality factor favours the stocks of companies that exhibit quality in their financial characteristics, such as high profitability or conservatism in their investment decisions.
Diversification can mitigate the risks of individual factors, reducing a portfolio’s overall risk – but far from all of it. Especially during crises, previously minimally or negatively correlated assets can become positively correlated, temporarily nullifying all the benefits of diversification. Combinations of factors, just like individual factors, can experience lengthy and sizeable drawdowns.
In practice, investors want to learn about a factor’s absolute return and its return relative to a benchmark. Absolute performance is important, because it determines total wealth. The relative performance is equally important for understanding how different investments compare. For our analysis, we construct factor portfolios by starting with the market portfolio and overlaying long-short factors. We construct these long-short factors to have 5% standard deviation in the full sample; the resulting factor portfolios therefore have 5% tracking error.
When we examine the performance of the factors relative to the market, the first thing we notice is that factors are prone to extreme negative outcomes. Mathematically speaking, the realised factor performance is far from normally distributed. We show in figure 1, the worst monthly factor return realisations in the US over the past 55 years for each of the six strategies and for an equally weighted six-factor portfolio. We also report estimates of how frequently we should expect losses of these magnitudes if we were to assume that returns are normally distributed.
If we assume normality for the diversified portfolio of six factors, we would have observed the worst realised monthly return of 7.9% only once every 117m years, or only once since dinosaurs ruled the world – yet we have experienced this extreme realisation in just the last 55 years.
To make things worse, factor returns can be serially correlated. Academic studies have shown that factors with high recent performance continue to outperform factors with poor recent performance. Momentum in factor returns can make the periods of underperformance even more painful when poor performance is followed by more poor performance. In figure 2, we display the drawdown characteristics for the value and momentum factors defined in both the large and small-cap spaces; although we focus only on these two factors, this behaviour is characteristic of the factors in general. The charts demonstrate that the factors are prone to severe drawdowns and decade-long periods of underperformance.
Product providers are happy to advertise the diversification benefits of the factors. Maybe, as the marketers suggest, we can eliminate all of these drawdown risks by combining factors into portfolios? In figure 3 we report the magnitudes of the three worst realised drawdown episodes for the six-factor portfolio over the past 55 years in the US and over the last 28 years, 1990-2017, in Europe and the developed markets. We also report the duration of the worst drawdown episodes in the US. To illustrate the deviation of the drawdown characteristics, we also provide a ‘well-behaved’ theoretical simulation, which assumes the returns are normally distributed and follow a random walk. We mark in red those realised drawdowns that exceed the average simulated drawdowns.
● In eight of nine cases across the regions, the realised drawdown for the portfolio of factors is worse than the ‘well-behaved’ simulation.
● In three of three US cases, the factor portfolio falls from peak-to-trough faster than it does in the ‘well-behaved’ simulation.
● The worst drawdown lasts almost twice as long as the average of the ‘well-behaved’ simulation.
● Diversification reduces risk, but does not eliminate it: even for a multi-factor portfolio, investors should expect decade-long drawdowns with the possibility of underperformance.
The reality is that correlations between factors are not constant over time and multiple factors may be exposed to the same underlying risk drivers. Investors who underestimate the risks associated with factors, and who expect more reliable alpha than plausible with factor investing, may be disappointed in performance. These investors may switch at the wrong time, lessening the likelihood they will meet their financial goals.
Factor investing can be a valuable way for investors to achieve their long-term return targets. At the same time, investors need to temper their expectations and account for the possibility of periods of underperformance.
Vitali Kalesnik is the head of equity research and Juhani Linnainmaa is an adviser at Research Affiliaties