In their June 1992 Journal of Finance article, “The Cross-Section of Expected Stock Returns,” professors Eugene Fama and Kenneth French revolutionized the way we think about investing. Prior to the publication of this study, the prevailing theory (known as the “capital asset pricing model,” or CAPM) was that the risk and return of a portfolio was largely determined by one factor: market beta. Fama and French added the size and value factors.
Since then, researchers have discovered what John Cochrane called a “zoo of factors.” And the mutual fund industry has developed product to meet the demand of investors who seek exposure to these factors. In some cases, they create the demand, or at least try to.
Eduard Van Gelderen, Joop Huij, and Georgi Kyosev contribute to the literature on factor-based investing with their January 2019 study “Factor Investing From Concept To Implementation.” The authors examined the performance of factor-based funds and compared their performance to those of actively managed funds. In addition, they examined the performance of individual investors, seeking to determine if they added value by timing their investments.
Their data sample covers the period January 1990 to December 2015 for U.S. funds (3,713 funds), and begins one year later for global funds (4,859 funds). The factors included in the study are market beta, size, value, momentum, profitability, and investment. Following is a summary of their findings:
- Mutual funds following factor investing strategies based on equity asset pricing anomalies, such as the small cap, value and momentum effects, significantly outperform traditional actively managed mutual funds.
- A buy-and-hold strategy for a random factor fund yields 110 basis points per annum in excess of the return earned by the average traditional actively managed mutual fund. The findings were statistically significant at the 1% confidence level.
- Only 17% of the traditional actively managed mutual funds earn positive alphas after fees. And funds with no factor exposures systematically fail to deliver positive net alphas that cannot be attributed to luck.
- While excess returns earned by factor funds net of fees are significantly smaller than the theoretical premiums of the asset pricing anomalies, they are still positive and statistically and economically significant.
- The actual returns that investors earn by investing in factor mutual funds are significantly lower because investors dynamically reallocate their funds both across factors and factor managers and subtract value—by attempting to time across factors, investors lose a large portion of the return they could earn with a buy-and-hold strategy.
- Although factor funds have attracted significant fund flows, it appears fund flows have been driven by factor funds earning high past returns and not by the funds providing factor exposures— past performance is the main driver of investor decisions and there isn’t a positive relationship between fund flows and future performance.
- The findings are robust to a global sample of mutual funds.
Van Gelderen, Huij, and Kyosev concluded: “Rather than timing factors and factor managers, investors would be better off by using a buy-and-hold strategy and selecting a multi-factor manager.”
They found that “if an investor would randomly select a factor fund that is exposed to two factors simultaneously and would apply a buy-and-hold strategy, this investor would earn 190 basis points per annum in excess of the return that is earned by the average traditional actively managed mutual fund.”
They also found that the figure rose as the number of factors a fund was exposed to increased (240 basis points per annum if the investor would have selected a manager that is exposed to three factors simultaneously, and 270 basis points per annum if the manager would be exposed to four or more factors simultaneously).
They noted their findings are consistent with those from prior studies (such as the 2007 study “What Are Stock Investors’ Actual Historical Returns? Evidence From Dollar-Weighted Returns” and the 2016 study “Timing Poorly: A Guide to Generating Poor Returns”), which found that the actual return earned by investors in hedge funds and small cap, value and growth mutual funds are significantly lower than the returns they could have earned with buy-and-hold strategies.
The conclusion we can draw is that individuals do invest in successful strategies, but destroy returns with their trading behavior. Even though factor funds deliver excess returns, investors have not been able to fully capture those returns due to their allocation decisions.
Van Gelderen, Huij, and Kyosev explain: “If investors believe in the value and momentum premiums but they only invest in value or momentum funds after a period of strong performance they lose a significant portion of the factor premium due to cyclicality in factor returns. A potential solution would be to buy both funds and hold on to them instead of moving assets across them.”
We have met the enemy and he is us!
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.