Flows Influence Time Variation Of Returns To Factors
Huang, Song and Xiang proceeded to determine how aggregate flow movements influence time variation of the size and value returns. Based on what we have seen, we should expect that SMB (HML) returns should be high in the periods when there are more flow-driven trades into small-cap (value) stocks relative to large-cap (growth) stocks and vice versa.
That is exactly what they found: “Aggregate flow-driven demand shifts across the small-cap and large-cap portfolios and demand shifts across the value and growth portfolios are statistically and economically significant drivers of the size and value returns, respectively.”
For example, they found that “A one-standard-deviation change of the aggregate FIT across the size spectrum is positively associated with a 1.65% change in quarterly SMB returns (6.61% on an annual basis).”
Importantly, the authors also found that “The flow-induced effects on factor returns significantly revert over longer horizons.” In other words, while inducing momentum in factor returns, the flows are just noise—while they positively affect contemporaneous factor returns, they don’t cancel out long-term premiums as factors experience strong reversals over longer horizons.
For example, they found that “A one-standard-deviation increase in the difference of flow-induced trades into value stocks and flow-induced trades into growth stocks over the prior five years, on average, predicts a 4.19% decrease in the HML returns over the next year.”
FIT Across Anomalies
In an April 2019 study, “Flow-Induced Trades and Asset Pricing Factors,” Huang, Song and Xiang expanded their work to include 50 well-known factors (anomalies to the CAPM). Their findings were consistent: “Our results indicate that these factors are heavily exposed to flow-driven ‘noise trader’ risk, which we further show is significantly priced.”
They added that the flow-driven effects on factor return dynamics can partially explain factor momentum (as well as the underperformance of large-sized mutual funds relative to small funds). Summarizing, the authors noted: “Our results indicate that these asset pricing factors are heavily exposed to non-fundamental risk that is due to mutual funds’ flow-driven demand shifts.”
Mutual fund investors are largely ignorant about systematic risks when allocating capital among actively managed equity mutual funds, causing them to trade based on noise, not fundamentals. Their naive performance-chasing behavior induces short-term momentum in factors but does not impact long-term premiums.
Note that the finding of momentum in factors is consistent with the findings of Tarun Gupta and Bryan Kelly in their December 2018 paper “Factor Momentum Everywhere.” They built and analyzed a large collection of 65 characteristic-based factors that are widely studied in the academic literature, including a variety of valuation ratios (e.g., earnings/price, book/market); factor exposures (e.g., betting against beta); size, investment and profitability metrics (e.g., market equity, sales growth, return on equity); idiosyncratic risk measures (e.g., stock volatility and skewness); and liquidity measures (e.g., Amihud illiquidity, share volume and bid-ask spread).
Following is a summary of their findings:
- Individual factors exhibit robust time series momentum, being positive for 59 of the 65 factors, and significantly positive in 49 cases.
- Robust momentum behavior among the common factors is responsible for a large fraction of the covariation among stocks.
- A portfolio strategy that buys the recent top-performing factors and sells poor-performing factors achieves significant investment performance above and beyond traditional stock momentum.
- On a stand-alone basis, factor momentum outperforms stock momentum, industry momentum, value and other commonly studied investment factors in terms of Sharpe ratio.
- While factor momentum and stock momentum are correlated, they are also complementary—factor momentum earns an economically large and statistically significant alpha after controlling for stock momentum and expenses.
- Demonstrating pervasiveness, factor momentum is a global phenomenon—it manifests equally strongly outside the U.S.—in a large global (ex. U.S.) sample, and Europe and Pacific region subsamples.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.