Swedroe: Sorting Through The Factor Zoo

Study examines the robustness of popular factors.

As Professor John Cochrane observed, the literature on investment factors now fills a veritable “factor zoo” with hundreds of options. How do investors select from among this huge array of possibilities?

Noah Beck, Jason Hsu, Vitali Kalesnik and Helge Kostka, authors of the paper “Will Your Factor Deliver? An Examination of Factor Robustness and Implementation Costs,” which appears in the September/October 2016 issue of CFA Institute Financial Analysts Journal, attempt to help investors navigate their way through this factor zoo by determining which exhibits are worth visiting.

The authors take a similar approach to the one my co-author, Andrew Berkin, and I took in our book, “Your Complete Guide to Factor-Based Investing.” For a factor to be considered worthy of investment, we established the following criteria. It must be:

• Persistent – It holds across long periods of time and different economic regimes.
• Pervasive – It holds across countries, regions, sectors and even asset classes.
• Robust – It holds for various definitions (e.g., there is a value premium whether it is measured by price-to-book, earnings, cash flow or sales).
• Investable – It holds up not just on paper, but after considering actual implementation issues, such as trading costs.
• Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.

Beck, Hsu, Kalesnik and Kostka used the following criteria:

• Factors should be grounded in a long and deep academic literature. They write: “A factor strategy that does not attract follow-on research usually means that the factor has not survived academic scrutiny.”
• Factors should be robust across various definitions. They shouldn’t be dependent on one very specific formulation (such as price-to-book as a value metric) but fail to work if other related versions are tested.
• Trading costs matter (which is similar to what my co-author and I called “investable”).
• Factors should be robust across geographies.

Using these criteria, Beck, Hsu, Kalesnik and Kostka identified a small group of popular equity factors: illiquidity, low beta, value, momentum, size and quality. The authors then formed portfolios on the basis of factor characteristics to evaluate a factor’s robustness. Following is a summary of their findings.

Low Beta

Low-beta stock portfolios consistently have had more attractive Sharpe ratios than high-beta stock portfolios, and they remain attractive after transaction costs. However, they did offer a caveat, just as we did. Like all factors, the low-beta premium is time-varying and can become crowded.

The popularity of the strategy, fueled both by the bear market of 2008 and the strategy’s acceptance as a legitimate investment option, has raised valuations. Thus, the authors warned that there might be disappointing returns in the near future.

In “Your Complete Guide to Factor-Based Investing,” we showed that when low-beta strategies were in a value regime (which they have been more than 60% of the time), they produce above-market returns with below-market risks. However, when they are in the growth regime, as is currently the case, while they still produce below-market risks, they also produce below-market returns.

Specifically, we demonstrate that when low-volatility stocks have value exposure, they have outperformed the market, returning an average of 9.5% annually versus the market’s 7.5%, and did so with lower volatility, with an annual standard deviation of 13.5% versus the market’s 16.5%.

However, when low-volatility stocks have growth exposure, they have underperformed, returning an average of 10.8% annually compared with the market’s 12.2%. The low-volatility factor did continue to have lower annual volatility, at 15.3% versus 20.3% for the market.

In our book, we added the following caveat regarding low beta: Low beta historically has characteristics related to the term factor, as well as to the value and profitability factors, and their related premiums. However, with interest rates at historic lows, it seems unlikely the term premium aspect will have the same payoff that it has in the past.

Value & Size

For all definitions of value, Beck, Hsu, Kalesnik and Kostka found economically significant differences in returns between value and growth stocks as well as statistically better risk-adjusted returns, consistent with our conclusions.

When it comes to size, on average, small-cap stocks have provided higher returns than large-cap stocks. However, taking into account the excess volatility risk associated with small-cap stocks, Sharpe ratios show no definition of small-stock portfolios deliver statistically significant risk-adjusted return benefits. The authors did add that small-cap portfolios generally also exhibit a value bias, and when they adjusted the small-cap excess return for the value effect, the size premium fell close to zero.

In an appendix to “Your Complete Guide to Factor-Based Investing,” we noted it is standard in the academic literature to use the 50^th percentile on the NYSE to separate small and large companies, which is what Beck, Hsu, Kalesnik and Kostka did.

However, it’s important to observe that this contrasts with the standard for all other factors, which use the 30^th percentile for breakpoints. That can lead to different conclusions. We presented the following table to demonstrate that point:

As expected, the more narrowly we define “small-cap” and “large-cap,” the larger the annual premium. The standard 50/50 size factor has the smallest annual premium and, notably, the premium resulting from the 30/30 construction was actually larger than the value premium (which was 4.83%). Furthermore, all the annual premiums are statistically significant (meaning they have a t-statistic greater than 2.0).

Momentum

Beck, Hsu, Kalesnik and Kostka concluded that the momentum strategy is far more reliable in the small-cap stock subuniverse. In the large-cap subuniverse, they found “the strategy often does not produce a statistically positive advantage because the definition of the momentum strategy varies.” They did note that “that the standard definition of momentum (months 2-12) is largely effective in the large-cap domain.” Like others, they observed that momentum did not work in Japan.

In our book, Andrew Berkin and I note that while momentum failed to work in Japan, this exception could easily be explained by a chance result. It could also be explained by the fact that value has worked strongly in Japan during this period, and the value and momentum factors tend to be negatively correlated. The interaction between value and momentum in Japan was explored in detail by Clifford Asness in his 2011 paper, “Momentum in Japan: The Exception That Proves the Rule.”

Beck, Hsu, Kalesnik and Kostka also found that once you include standard estimates of transaction costs, the advantages of momentum disappear. However, they cite the same research we did, which showed that patient trading changes the outcome, as implementation costs are much lower.

They note that active managers (and I would add to that any manager who doesn’t slavishly adhere to an index, such as the managers of asset class strategies that aim to provide exposure to a diversified set of stocks within a common segment of the market) have a marked advantage over traditional index implementers in this regard.

Specifically, the authors write that “active managers can be flexible in choosing which securities to trade on the basis of current liquidity conditions. They can be patient in placing their trades. Finally, they can mask their trades to prevent front running. Interestingly, the value that active managers can provide arises not necessarily from their stock-picking skills but, rather, from their ability to actively manage transaction costs in liquidity-taking strategies.”

I would add that the easiest way to use momentum is for a fund to avoid the purchase of negative-momentum stocks and also by possibly delaying the sale of high-momentum stocks. In both cases, turnover—and thus trading costs—are actually reduced.

Illiquidity & Quality
Beck, Hsu, Kalesnik and Kostka found that, in the U.S., in all cases, portfolios of illiquid stocks outperformed the more liquid ones, with an economically significant difference in returns. With respect to Sharpe ratios, they observed a uniform and significant risk-adjusted return benefit from holding illiquid stocks. When they looked at international evidence, they found weak results for the illiquidity premium, even in small stocks.

Thus, they concluded there is mixed evidence in favor of an illiquidity premium. However, once they considered transaction costs, they concluded that most of the advantages of illiquidity disappear. Note that our book did not include illiquidity as one of the factors that met our criteria.

As we did in “Your Complete Guide to Factor-Based Investing,” the study’s authors note that, theoretically, “it is hard to argue that high-quality companies should earn a risk premium; labeling these companies ‘quality’ assumes that they are less risky.” They found “few signs of a premium or premium persistence across multiple definitions of quality.”

Summary

While Andrew Berkin and I like the criteria Beck, Hsu, Kalesnik and Kostka established, we don’t necessarily agree with all of their conclusions. That’s fine, because reasonable people can disagree. That’s also why Berkin and I presented all of the evidence regarding the six criteria we established in our book—so that investors can make their own judgments as to which exhibits they want to visit, and how much of an allocation they want to make to a particular factor.

But we do agree with this warning Beck, Hsu, Kalesnik and Kostka offer about trying to time factors: If investors “rotate between factors on the basis of recent performance, they run the risk of disinvesting when they should invest and vice versa. Investors who choose factor-based strategies will benefit from a disciplined buy-and-hold policy that resolutely disregards short- and medium-term performance.”

It’s similar to one we offered in the conclusion of our book: “We also would like to offer these words of caution. First, as we have discussed, all factors—including the ones we have recommended—have experienced long periods of underperformance. So, before investing, be sure that you believe strongly in the rationale behind the factor and the reasons why you trust it will persist in the long run. Without this strong belief, it is unlikely that you will be able to maintain discipline during the inevitable long periods of underperformance. And discipline is one of the keys to being a successful investor. Finally, because there is no way to know which factors will deliver premiums in the future, we recommend that you build a portfolio broadly diversified across them. Remember, it has been said that diversification is the only free lunch in investing. Thus, we suggest you eat as much of it as you can!”

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.