Professors Eugene Fama and Kenneth French have a new paper, “Incremental Variables and the Investment Opportunity Set,” that provides some important insights for investors considering funds designed to supply exposure to multiple factors, or styles, of investing.
In their study, they note: “Much asset pricing research is a search for variables that improve understanding of the cross section of expected returns. Researchers often claim success if a sort on their candidate produces a large spread in average returns. A better measure, however, is the variable’s incremental contribution to the return spread produced by a model that includes the variables already known to predict returns.”
The paper’s important message is that factors (systematic variables such as size, value, momentum and profitability) that possess strong marginal explanatory power in cross-section asset-pricing regressions and that exhibit large premiums typically show much less power to produce incremental improvements to average portfolio returns.
Which Exhibits In The Factor Zoo Should You Visit?
The factors to which investors should allocate assets, and the funds they should select to gain exposure to their choices, are important issues. Further complicating the problem is that, as professor John Cochrane has noted, the literature on factors now fills a veritable “factor zoo” of more than 300 options. How do investors select from this huge array of possibilities?
Following are the criteria I would recommend investors consider before allocating assets to a given factor.
- Strong evidence in the academic literature that premiums associated with the factor are persistent across both time and economic regimes as well as pervasive across geographic regions, countries, industries and sectors. The case for a factor can be made even more compelling when the evidence exists across asset classes (stocks, bonds, commodities, currencies). Examples where this is the case include value, momentum and carry.
- The factor has exhibited significant premiums that are expected to persist in the future. Not only should we understand why the premium exists, but there should be a strong basis for believing it will persist into the future. In other words, there needs to be an intellectual foundation with compelling logic (whether risk or behavioral).
- The factor must have returns history available for bad times. Factor risk premiums exist because they reward an investor’s willingness to endure losses during down times in the market.
- The factor’s results are not subsumed by already-known factors. The factor should have its own explanatory power when it comes to the cross section of returns.
- The factor should be implementable in liquid, traded investments. This is especially important for large investors where scale is required.
Additionally, inclusion of the factor among asset pricing models now in common use by academics would be a strong argument in support of an allocation to it. The most commonly included today are beta, size, value, momentum and profitability/quality.
Combine Securities, Not Factors
Once an investor has chosen the factors he or she wants exposure to, the next decision should involve whether to target the factors individually, separately or through a multistyle fund. For instance, an investor could decide to own three funds, each of which targets the size, value and momentum factors individually. Alternatively, the investor could choose to invest in one multistyle fund that targets all three.
As Roger Clarke, Harindra De Silva and Steven Thorley explain in their October 2015 paper, “Factor Portfolios and Efficient Factor Investing,” it is far better to combine individual securities to achieve optimal portfolios than to combine factors.
This is intuitive. For example, suppose one chooses to invest in both the size and value factors. Constructing a portfolio at the security level would mean buying small and value stocks. But combining them at the factor level would mean buying a bunch of small stocks and also a bunch of value stocks. The small stocks would include some with a lot of growth exposure (little value), while the value stocks would include some that are large (not small). This would be less optimal.
And it would be even less optimal if the strategy involved both long and short positions in the factors. The reason is that one factor could be long a security and the other factor could be short.
Thus, if the factors were targeted separately, the investor would not only be paying two fees for no net position, but would also be incurring unnecessary trading costs. (Note that there are funds, such as AQR’s Style Premia Alternative Fund, QSPIX, that avoid these problems. And in the interest of full disclosure, my firm, Buckingham, recommends AQR funds in constructing client portfolios.) Using multistyle funds is clearly optimal.
And that brings us back to the issue addressed by Fama and French: What’s the incremental impact of adding exposures to additional factors? Here again, intuition can help us.