Factor Investing Works

We have written often about the underperformance of active management.

But a new study has found that one class of mutual funds outperforms the rest by 110bps per year: funds that focus on the quantitative factors that predict equity returns. Examining data from the CRSP Survivorship Bias Free Mutual Fund Database from 1990 to 2015, the authors of the study found that, while only 41% of mutual funds generate alpha, the majority of those targeting low beta, value, small cap, profitability, and investments do generate alpha.
 
Figure 1: Percentage of Funds Generating Alpha

Source: Eduard van Gelderen, Joop Huij, and Georgi Kyosev, “Factor Investing From Concept To Implementation”

In short, the evidence suggests that evidence-based investing works.

However, investors do not necessarily realize the full benefits of academic factor investing. The study found that factor funds underperform their academic factors by about 3% per year. And investors, because they buy and sell these funds, underperform a buy-and-hold factor fund by about an additional 1%.

Figure 2: Mutual Fund Returns vs. Investor Returns

Source: van Gelderen, et al.

So why is there a gap between the academic factors and what actual investors achieve?

We believe the answer is two-fold.

First, we believe that capacity is the single biggest issue causing the gap between academic factor returns and the performance of factor funds. Generally, the smaller in AUM the factor fund is, the better equipped it is to capture the academic factor exposure. For example, given trading volumes, we estimate that a single fund investing in the 9th and 10th deciles of value in the US has a capacity of about $2B AUM. Meanwhile, Vanguard’s US Small Value Fund has $12B in assets while DFA’s US Small Value Fund has $15B.

Second, investors need to buy and hold. Buying and selling factor funds based on recent performance is the best way to underperform. Investors should commit in advance to holding factor funds, we think for a minimum of three years.

The return premiums from factor exposure are volatile. But this uncertainty declines over longer time horizons. For example, the chart below—from a new paper by Eugene Fama and Ken French—shows that small value strategies are much more likely to outperform the market over longer time horizons.

Figure 3: Probability of Small Value Outperforming the Market (Jul 1963 to Dec 2016)

Source: Eugene Fama and Ken French, “Volatility Lessons”
 
Long-term investors can benefit from tilting their portfolios toward the factors that have historically predicted equity returns. But it is important both to have a long time horizon and to ensure that the product actually provides exposure to the factor, as too many firms are selling gin and tonics that are mostly tonic and ice.