Factor Investing’s Roller Coaster Ride

February 18, 2016

  Annualized Premium Relative Max Drawdown Max Drawdown Length
Value 2.31% -33.85% 6 years
Size 0.92% -31.90% 8 years
Momentum 3.69% -13.19% 8 years
Minimum Volatility 0.63% -21.86% 13 years
Dividend Growth 2.45% -29.52% 6 years


In defense of the minimum volatility tilt, there is no expectation for it to outperform the market on a total return basis. Rather, it is expected to outperform on a risk-adjusted basis.

However, since most individual investors exhibit severe aversion to the use of leverage, I believe it is worth the comparison on a total return basis.

Weak Hands Fold Easily

So as easy as it is to say a factor tilt will be a strategic allocation, the variation of the premiums that lead to significant, gut-wrenching relative drawdowns can make it hard to actually maintain the strategic allocation.

Worse, factors can actually magnify absolute drawdowns as well. In effect, we’re taking the market and layering on top another return source. While the expectation of that return source is additive, so is the volatility.

Let’s consider the value tilt again. While the annualized excess return was estimated to be approximately 2.31%, the volatility of that premium over the past 20 years was 13.3%. So by taking a value tilt, we’re adding an extra 2.3% to our expected return, but also bringing in a new source of volatility.

Volatility Can Makes Losses Worse

Sometimes that volatility may diversify against market returns—but other times it may compound to make them worse. For example, while the S&P 500 was down -36.8% in 2008, the value tilted portfolio was down -47.8%.

So, over the 20-year period, a value tilt would have added 2.31% per year to your returns. To put that in dollar terms, $100,000 invested in 1995 would have been worth an extra $248,821 at the end of 2016 if invested in a value-tilt portfolio instead of the S&P 500.

Along the way, however, you would have gone through a six-year period of trailing the market by up to -33.85% and seen nearly half your wealth wiped out in 2008. Needless to say, it would have been hard not to “fold” in those scenarios.

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