Research Affiliates: The Incredible Shrinking Factor Return

April 27, 2017

Key Points

  • We find slippage between the factor returns realized by mutual fund managers and the theoretical factor returns “earned” by long–short paper portfolios over the period 1991–2016.
  • The source of the slippage appears to be costs related to implementation, such as trading costs, missed trades, expenses of shorting, manager fees, stale prices, bid–ask spreads, and so forth.
  • Our research shows that over the last quarter-century the real-world return for the value and market factors is halved or worse than theoretical factor returns imply, and the momentum factor has provided no benefit whatever to the end-investor.


“Why, sometimes I’ve believed as many as six impossible things before breakfast.”
—The White Queen, from Lewis Carroll’s Through the Looking Glass


In 2016, Research Affiliates published a series of articles1 challenging the “smart beta” revolution. We pointed out that, while there is merit in many factor tilt and smart beta strategies, performance chasing in these strategies—buying the popular outperforming strategies whose relative valuations are at extremely high levels—can be just as dangerous as performance chasing in other realms of asset management. We observe in factors and smart beta strategies that valuations matter just as they do in stock selection and asset allocation (i.e., lower relative valuations positively correlate with higher subsequent returns, and vice versa). 

In this article, the first in a series to be published in 2017, we attempt to measure the slippage between the factor returns realized by fund managers and the theoretical factor returns constructed from long–short paper portfolios, and potential reasons for this slippage, or performance shortfall. Theoretical concepts, such as long–short factor portfolios, although helpful in advancing our understanding of a subject, are typically idealized approximations of the real world, built on a foundation of simplifying core assumptions, which are usually implausible at best. 

We find that managers who favor high factor loadings for market beta, value, or momentum generally do not derive nearly as much incremental return, relative to low beta, growth, or contrarian funds, respectively, as factor return histories would suggest. Well over half of the factor return for market beta and for value (defined as HML) disappears, as does essentially all of the momentum factor return. By all appearances, Alice’s “Drink Me” potion, responsible for shrinking her so she can pass through the door to Wonderland, has found its way into real-world factor returns. 


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