This article is part of a regular series of thought leadership pieces from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
In recent years, factor investing has come into vogue as a better mousetrap than traditional stock picking. Proponents of factor investing argue that instead of focusing on picking individual securities, investing in an index weighted toward a specific factor can more consistently harvest the associated premium.
Numerous studies on empirical asset pricing have shown that there are many characteristics that can deliver superior risk-adjusted returns, including value, size, momentum, quality, low volatility and high yield. In their five-factor model, Eugene Fama and Kenneth French identify four nonmarket factors: value, size, investment and profitability.
Long-Only Tilts
For long-only investors, factors come in the format of tilts. For example, a long-only value-factor portfolio will hold exposure to cheap securities, or a long-only size- factor portfolio will hold exposure to small companies.
While each of the most popular factors differs in definition and the theories for why it might exist, they all share a similar, promising allure: excess risk-adjusted returns.
But these excess risk-adjusted returns are not constant. Consider a value-tilt portfolio over the last 20 years. It has, on an annualized basis, outperformed the S&P 500 by 2.3% a year. Investors, however, do not experience “average,” and the yearly ride value took investors on was quite a roller coaster.
Long-Term Premiums & Volatility
It is important to point out that for the long-term premiums to exist in these factors, they must be volatile over time. The excess return generated by one investor is at the detriment of another.
If the returns were not time-varying, they would be viewed as “free.” In that case, there would be significant money inflow into the style, driving up prices and valuations and driving down forward expected returns until the premium converged to zero.
Quite simply, volatility in the premium itself causes weak hands to fold, passing the premium to the strong hands that remain.
This volatility, however, means that factors can go through significant and prolonged relative drawdowns:
