Factor-based investing has achieved great popularity, with hundreds of billions of dollars in assets flowing into funds that offer exposure to factors such as size, value, momentum, quality, low volatility and carry. With the flood of assets into factor-based funds, many have questioned whether factors that have in the past produced premiums will continue to do so. In other words, now that everyone knows about these factors, have they been arbitrated away?
In addition, a whole other school of factor skeptics believes that the findings pertaining to them were nothing more than random outcomes from data mining exercises.
Adding fuel to concerns about the sustainability of factor premiums is that the value premium has been slightly negative since the beginning of 2005. Of course, students of economic history know that all factors, including market beta, go through long periods of underperformance. Thus, the value factor’s lengthy underperformance should not come as a surprise. Instead, it highlights the importance of diversification across factors when designing a portfolio.
Popularity’s Supposed Curse
Whenever I’m asked about the “curse of popularity” and how it applies to factor-based investing, I first acknowledge it certainly is possible that popularity can lead to cash flows, which could raise the valuations of the long side of the factor and lower the valuations of the short side, leading the premium to shrink or even be eliminated.
On the other hand, I also observe that if a factor has a risk-based explanation (and value has both a risk-based and behavioral-based explanations), while the premium could shrink, you cannot arbitrage away risk.
My next step is to point out that if the publication of findings on the value premium actually had led to cash flows that, in turn, have caused it to disappear, we should have seen massive outperformance in value stocks as investors purchased value stocks and sold growth stocks. Yet the last 13 years have witnessed the reverse in terms of performance. Thus, that proposition cannot be true.
In addition, as David Blitz demonstrated in his February 2017 paper, “Are Exchange-Traded Funds Harvesting Factor Premiums?”, while some ETFs are specifically designed for harvesting factor premiums, other ETFs implicitly go against these factors.
Specifically, Blitz found that “from a factor investing perspective, smart-beta ETFs tend to provide the right factor exposures, while conventional ETFs tend to be on the other side of the trade with the wrong factor exposures. In other words, these two groups of investors are essentially betting against each other.”
The bottom line is that, despite what many investors believe, a massive net inflow into value stocks relative to growth stocks has not occurred.
Test Of Factor-Based Investing
Most factor-based funds are long-only, meaning they provide exposure not only to the factor being targeted, but also to market beta. On the other hand, AQR’s Style Premia Alternative Fund (QSPRX, 1.5% expense ratio), by virtue of being a long/short fund, is a pure factor fund, meaning it has no exposure to market beta.
Its exposures are to the value, momentum, defensive (quality) and carry factors. It provides those exposures across four asset classes. (In the interest of full disclosure, my firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)
I wrote about this fund, and my position on it, about a year after the strategy (QSPIX, with a 1.6% expense ratio, which was the only version available until November 2014) was launched.* Many skeptics questioned the strategy, its relatively high expense ratio, its use of leverage and its use of derivatives.
Today we have just over four years of live returns for the strategy. Thus, we can see how the live fund has performed relative to expectations, which were for a 7% forward-looking return and 10% estimated volatility.** From inception through year-end 2017, the strategy returned 8.5% (exceeding expectations) with a standard deviation of just 6.8% (well below expectations).
The result has been a Sharpe ratio of well over 1. Compare that to the long-term Sharpe ratio of equities, which is about 0.4. The four full-year returns were 11.4% (2014), 8.8% (2015), -0.4 percent (2016) and 12.1% (2017).
Given the live results, which include all transaction costs, it seems clear the rumors of the death of factor-based investing are premature.
*Discussion of QSPRX and QSPIX is provided for informational purposes only and is not intended to serve as specific investment or financial advice. This list of funds does not constitute a recommendation to purchase a single specific security, and it should not be assumed that the securities referenced herein were or will prove to be profitable. Prior to making any investment, an investor should carefully consider the fund’s risks and investment objectives and evaluate all offering materials and other documents associated with the investment.
**It is important to understand that forward-looking returns/expected returns are the mean of a very wide potential distribution of possible returns. Thus, they are not a guarantee of future results. Expected returns are forward-looking forecasts and are subject to numerous assumptions, risks and uncertainties, which change over time, and actual results may differ materially from those anticipated in an expected return forecast. Expected return forecasts are hypothetical in nature and should not be interpreted as a demonstration of actual performance results or be interpreted as a target return.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.