Financial research has uncovered many relationships between investment factors and security returns. Given that popularity is a curse in investing, the growing popularity of factor investing has led to worries that factors have become overvalued, posing risks to investors in these strategies.
For investors, an important question is whether the past relationship between factors and returns will continue after the research has been published and factor investing becomes popular. Said another way, if everyone knows about it, should we expect the premium to continue outside of the sample period?
In the introduction of our new book, “Your Complete Guide to Factor-Based Investing: The Way Smart Money Invests Today,” my coauthor Andrew Berkin and I provide five criteria that a factor should be required to meet before the premium can be expected to continue: The factor should be persistent, pervasive, robust, investable and have logical, risk-based and/or behavioral-based explanations.
Does Popularity Destroy Persistence?
Chapters 1 through 7 of the book provide evidence and explanations for why we believe the premiums for each factor addressed (beta, size, value, momentum, profitability/quality, term and carry) should be expected to continue.
However, this conclusion says nothing about the size of the premiums, provoking the question: Does the publication of research impact the future size of premiums? The question is important on two fronts.
First, if anomalies are the result of behavioral errors—or even investor preferences—and publication draws the attention of sophisticated investors, it is possible that post-publication arbitrage would cause the premiums to disappear. Investors seeking to capture the identified premiums could quickly move prices in a manner that reduces the return spread between assets with high and low factor exposure.
However, as we explain in the book, limits to arbitrage (such as aversion to shorting and its high cost) can prevent arbitrageurs from correcting pricing mistakes. And the research shows this tends to be the case when mispricing exists in less liquid stocks, where trading costs are high.
Second, even if the premium is fully explained by economic risks, as more cash flows into funds acting to capture the premium, the size of the premium will be affected. At first, publication will trigger inflows of capital, which drives prices higher and thus generates higher returns. However, these higher returns are temporary because subsequent future returns will be lower.