Anyone hoping to benefit from factor investing should be willing to accept significant periods of underperformance, says Daniel Ben-Ami
At a glance
• Although it is widely accepted that factor investing outperforms over the long term, there can be sustained periods of underperformance for particular factors.
• The performance of different factors can dramatically shift during financial crises.
• It can also help to set performance against the backdrop of different market and economic conditions as well as shifts in investor sentiment.
• One of the pioneers of smart beta investing is arguing that its growing popularity has artificially inflated the prices of some factors.
For the arch-pragmatist the key test for any product is simple. The main criterion is how well it works.
However, it does not take long to realise that this is more difficult to gauge than might first appear. Even if the brief is relatively narrow there is usually a trade-off between several different elements.
The analogy with a racing car is instructive. Its goal is simply to win races. No need for the designer to concern himself with carrying passengers or carting around heavy shopping. But even in this case it is not sufficient just to think about speed. Apart from drag racing, it is important not just to look at straight-line speed but speed round a bend as well. Then there is the effect of different weather conditions, the importance of acceleration and the range of the car. Before long, it becomes clear that the assessment of such a car needs to include multiple considerations.
Nor does any single race provide a definitive test. Some tracks may suit some cars more than others. The quality of the driver and indeed the whole racing team also has an important bearing. Accurate comparisons are far from straightforward.
The parallel with assessing the performance of any factor-investing strategy is not that far-fetched. Looking at short-term performance has its place but it is of limited use. It is not that it is illegitimate but it is only one of many factors to consider. That then begs the question of what would be a more meaningful metric.
Neither are there any absolute answers. An approach that is perfect for one pension fund might not be suitable for another.
Nick Motson, a senior lecturer in finance at Cass Business School in London, argues that factor-investing strategies can expect to outperform over the long term. It is a widespread opinion among experts. The catch is that investors have to be prepared to accept short-term volatility. “Anybody who believes that it is going to be a straight 150-basis-point-per-year alpha-type number from trying to harvest these factors is living in cloud cuckoo land,” he says.
A similar point was made, albeit less colourfully, in a paper by two analysts from S&P Dow Jones Indices entitled What Is in Your Smart Beta Portfolio?1: “There is empirical evidence to suggest that factor strategies have historically generated risk-adjusted returns in the long run, but they can also exhibit a high amount of cyclicality in the short run, which may include long periods of underperformance.”
Motson points to value investing as an example of an approach that retains its potency even if it has not performed well recently. “Obviously, some people are running around with their hair on fire saying ‘oh my god, the [value] premium is dead’ but it’s not,” he says.
A similar observation on investing in small caps – arguably a particular form of factor investing – was recounted by me in an article2 in the February 2016 issue of IPE. In 1986, Paul Marsh and Andrew Dimson, two prominent academics, published a landmark paper arguing there was evidence that small companies outperformed large ones. But in 1998 they published another paper bemoaning the apparent disappearance of the effect. Then, soon after the latter paper was published, the effect seemed to reappear again.
Indeed, the need to consider factor investing from a long-term perspective was already apparent in a seminal report published in 2009. Back then, shortly after the global financial crisis, three academics wrote an evaluation of active management for the Norwegian government pension fund ‘Evaluation of Active Management of the Norwegian Government Pension Fund’3. They concluded that the giant sovereign wealth fund would be best served by adopting factor investing. This finding helped to draw the attention of the pensions industry to what at that time was a relatively little-known approach.
But the report also sounded a note of caution. “One important lesson from the financial crisis is that some factors, eg, liquidity and volatility, have distributions that are highly skewed with long left tails,” it said. “In other words, returns on these factors may be relatively stable for much of the time but periodically experience very large negative returns.”
For anyone with a long-term time horizon, such crises should not be ignored, for they are fairly common. Just think back from the 2007-08 financial crisis to the bursting of the dot-com bubble in the early 2000s, the Asian financial crisis of 1997-08 and the Mexican ‘tequila crisis’ of 1994. Crises with international effects seem to hit once a decade or so.
However, even leaving aside such events, gauging performance is a tricky matter. Different factors benefit from different conditions.
Raimund Müller, the head of UBS ETF for Switzerland and Liechtenstein, generalises about the effects of different market conditions. In his view, strong bull markets generally favour traditional passive vehicles such as market-weighted indices. However, smart beta comes into its own in other environments. “Once the markets are negative, sideways or slightly positive, it is better to go for factor investing,” he says.
Since, by definition, investors cannot be sure what the future will hold, such products should offer a strong appeal to many. They should benefit from market rises, albeit not by as much as a traditional passive fund, while also offering a degree of protection against market falls.
MSCI, in contrast, has examined how investment factors perform in different economic environments rather than market conditions. In April 2014, it published a paper on Index Providing in Changing Economic Environments. The focus, as the title suggests, was on different stages of the economic cycle. On the basis of 40 years of data it concluded, among many other things, that quality has generally outperformed in an environment of slower growth. In contrast, minimum volatility does well when slowing growth is combined with low inflation.
The S&P study cited above went a step further in examining the performance of factor investing in the US under what it calls three different factor regimes: the market cycle; the business (or economic) cycle; and the investor sentiment regime. Although the cycle of the stockmarket and the economy are related, the index provider argues they should not be conflated. Equity performance is an imperfect predictor of economic activity .
From its analysis of the performance of the US data from 1994 to 2014 it becomes clear that different factors do well in different conditions (see figure). For example, quality performs well during both bullish and bearish market cycles. In contrast, growth stocks like both bullish phases and recovery phases but they tend to dislike bearish markets. Similarly, different economic conditions benefit different factors.
Daniel Ung, one of the authors of the S&P report, says that it would be possible to do a similar report based on European data. But to begin with, it made sense of focus on the US.
But perhaps the most surprising recent comments on the performance of factor investing come from Rob Arnott. As the chairman and chief executive officer of Research Affiliates, he might be expected to be an ardent advocate. Yet recently he co-authored a paper entitled How Can ‘Smart Beta’ Go Horribly Wrong?4.
The thrust of the argument seems to be that the popularity of smart beta has artificially pushed up the price of certain factors. “Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive. Is the financial engineering community at risk of ‘encouraging’ performance chasing, under the rubric of smart beta? If so, then smart beta is, well, not very smart.” (Original emphasis)
Sceptics might contend that Research Affiliates is reacting against the entry of so many new entrants to the field. When the company was founded in 2002 the approach was a niche pursuit. Since then, a multiplicity of players has come to offer products in the area.
Nevertheless, its conclusions are worth pondering. “Today, only the value category shows some degree of relative cheapness, precisely because its recent performance has been weak! Generally speaking, normal factor returns, net of changes in valuation levels, are much lower than recent returns suggest. Investors entering the space should adjust their expectations accordingly.” The paper is the first in a proposed series, so it will be interesting to see how the arguments shape up.
One final thing to bear in mind is that, for many pension funds, focusing on return and risk is considered insufficient. It has become increasingly common for investors to insist that environmental, social and governance (ESG) are part of the mix. In some cases this may be primarily for ethical considerations but many ESG proponents argue that it also helps to identify good performance. Daniel Ung of S&P says that it has become particularly common to incorporate governance concerns into factor-investing approaches.
Although there are limits to simple pragmatism when choosing investment strategies, it is also possible to go too for in the other direction. The range of choice in factor investing nowadays can easily become debilitating. Not only is there a huge range of possible factors – a situation now routinely described as the ‘factor zoo’ – but there are multiple providers and several different ways of accessing strategies.
One of the few certainties is that short-term performance is a poor guide to selection. A key consideration is that it is widely accepted that factor investing tends to outperform in the long term. However, even its most ardent supporters generally accept that particular factors can fall out of favour for significant lengths of time.
How new is factor investing?
Perhaps the obvious place to gauge the popularity of factor investing is where most investigations seem to start nowadays – Google. Only, this time, the entry point is not a Google search itself but a look at how popular certain search terms have been over time.
Key ‘factor investing’ into Google Trends and there is virtually nothing until late 2014. Of course, there are rough synonyms for factor investing, so it is worth trying them as well. Smart beta does not make an appearance until mid-2011 (although these results might be slightly compromised by the existence of what appears to be a satellite receiver called the Azbox Smart Beta).
Alternative beta starts to appear in 2013, while Strategic beta does not yield enough search volume to yield results.
IPE, as might be expected, is ahead of Google, with smart beta mentioned at least as far back as June 2006. Factor investing does not appear as a term until 2014.
Such results suggest that even among investment professionals, at least the terms themselves are relatively new. Of course, in different guises they have existed for much longer. Value and growth, for instance, were more often referred to as forms of style investing until recently. Investing in smaller companies is also, arguably, a form of factor investing. Such practical distinctions go back to the 1980s.
In the academic arena the idea of investment factors goes back much further. Arbitrage pricing theory, which recognises the existence of specific factors, was devised by Stephen Ross, now a professor at the MIT Sloan School of Management, in 1976. This, in turn, built on earlier theoretical discussions and provided the basis for subsequent refinements.
It is certainly the case that sales of smart beta products have surged recently. A July 2015 study by Spence Johnson, a specialist research firm, estimated that the European market had grown by 32% in 2014. It found that cost reduction was playing an important role in growing demand for smart beta products. However, improvements in return, diversification and risk reduction also played a role. By far the largest segment of the market was in equities, although bonds, multi-asset and alternatives also had some representation.
An April 2014 global survey by Russell Indexes found that 32% of asset owners had smart beta allocations. Although the adoption was greatest among the largest asset owners, the smaller ones were quickly following.
A follow-up survey of 214 assets owners conducted in February 2015 found that smart beta was more prevalent in Europe and North America. Some 70% of European respondents with $10bn in assets or more had some allocation to smart beta compared with about 25% in North America. Some 61% of respondents were looking to increase their allocation in the following 18 months.
Although the ideas behind factor investing had been around for decades it only came into its own in the wake of the 2008-09 financial crisis. Since then, it has gone from a marginal to a mainstream investment approach.
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