Facts and fantasies about Factor Based Investing

In recent years, factor-based investing (FBI) solutions have been bestsellers. But FBI’s success is not a foregone conclusion, and there are plenty of quirks and misprints in the literature about it. So should we do things by the book, or is it all pulp fiction? In fact, do investors need a novel approach?

FACT: Multi-factor strategies from different providers can be very different

There is a wide spectrum of ways to implement multi-factor strategies. How providers target a particular factor varies from simple, transparent approaches, to complex, proprietary approaches. Multi-factor solutions can vary; they can include simply adding together single-factor strategies or trying to target multiple factors in one joint analysis, using complex proprietary approaches. 

Investors need to weigh the potential for higher returns from more complex approaches against the risk of losing transparency and therefore the additional governance requirements.

FANTASY: FBI performance never lags market-cap strategies

Typically, factor-based equities tend to own fewer of the largest stocks than market cap peers. If larger stocks strongly outperform the broader market, the factor based strategy will likely under-perform a market cap strategy. A good example of this is the recent outperformance of US technology stocks. Many factor strategies (including value and low volatility, amongst others) tend to diversify away from this large sector, which has resulted in relative underperformance for FBI strategies versus US market-cap benchmarks.

FBI targets factors that the investor believes will be rewarded over the long-term. It is this conviction that should drive the investment decision, not the reliance on spurious sales statements that factors guarantee superior performance in the future. As everyone’s favourite Danish quantum physicist, Niels Bohr said: “it is difficult to make predictions, especially about the future”. While no investor can be sure that a particular factor will add value, some factor strategies take less equity market risk than market-cap indices and aim to improve risk-adjusted returns rather than to beat market-cap equity indices significantly over the long term.

FANTASY: Multi-factor strategies always outperform single-factor strategies

Multi-factor investing diversifies investment exposure, reducing reliance on any single factor. Yet it would be a mistake to say that multi-factor strategies are always stronger than single-factor strategies. Multi-factor strategies reduce an investor’s reliance on timing the market, or making the ‘right’ call. They will most likely underperform the strongest factor of the year, but should offer some insulation against the weaker ones. Choosing multi-factor over single-factor is all about the investor's conviction in their specific views.

FANTASY: Past performance is an accurate and reliable estimate of future returns

Certain factors have historically outperformed market-cap based indices. But investors who do not wish to be the authors of their own misfortune should not view these factors’ continuing ability to outperform as an incontrovertible truth. Performance may not be repeatable, either because the investment strategy is not diversified across styles, or is being eroded slowly due to factor overcrowding. Individual factor strategies designed now may be skewed by hindsight (“selection bias”) and future returns will likely be lower than any back test suggests.

It is human to want to hang on to certainties; this is part of the reason why ex-post (historical) return measures, such as back-tests, loom large in the minds of investors. But ex ante (future) measures may be at least as good a predictor of what is going to happen. These build in market expectations, looking at the facts on the ground today. In some cases, it is more of a risk to focus on the certainty (what has happened) than the uncertainty (what will happen).

Factors can offer investors an opportunity to precisely hone their market exposure, or smooth a portfolio’s risk-return profile. But take note — FBI is a tool for clients to use to express their convictions, not an outcome which guarantees success