Conservative approach pays off best for factor investing, suggests Robeco’s Joop Huij
Joop Huij, senior vice president Quantitative Research at Robeco, has found that a conservative approach to factor investing may produce the best outcomes, on the basis of a study into the performance of some 7,000 funds.
Factor investing is in vogue – value, low volatility, momentum, small cap – but is it really effective?
Whilst many studies have looked at the concept of factor investing, few have investigated how it actually works in practice. As a quantitative researcher at Robeco, I have examined approximately 7000 funds over the period 1990-2010 to find out whether active managers who adopt factor-based investment strategies consistently outperform their benchmarks. I used a regression-based method to show fund exposure to factors, and the results indicate that factor investing really works.
But some factors perform better than others…
While such factor-based strategies can be highly effective; I also observed that this is not necessarily the case for all factors. You can improve the likelihood of success by investing in proven factors – so we need to establish which ones work and which do not.
Factors such as value and low volatility have been the object of considerable academic focus, resulting in a degree of consensus on the existence of statistical patterns and their significance. Others, such as short- and long-term reversal, which also formed part of my study, are still relatively unknown.
While many mutual funds in our database are exposed to the small cap and value factors, other factors are less popular. For instance, only 6% of the active-management strategies are identified as low-volatility and just a small proportion of these consciously apply this strategy, for example, by applying volatility screening. Still fewer of the funds we reviewed – a mere 1%-2% – consistently follow a momentum strategy.
Short-term reversal is an example of a strategy that does not perform well. It aims to take advantage of stocks with recent poor performance – theoretically resulting from investor overreaction to stock-specific news – that will outperform in the near future, or vice versa. However, 96% of all short- term reversal funds underperform the market. Perhaps not a complete surprise as this strategy requires frequent portfolio rebalancing, resulting in high trading costs that eat into net performance.
Being conservative pays off
A more conservative approach to factor investing appears to work best – one that considers only those factors for which there is a large amount of evidence, as anomalies don’t just disappear.
The example of the momentum factor highlights the need for careful implementation. 38% of active managers that include this factor achieve outperformance. This is less than in the value or low volatility universes, but still substantially more than the group with no factor exposure. However, some managers generate substantial underperformance. This is not totally unexpected as this is a high-risk strategy where excessive turnover can result in high trading costs and exposure to unrewarded risk can detract from performance.
Can you afford not to?
Our study shows that a fund that does not engage in factor investing demonstrates an average historical underperformance of 189 basis points. That is fairly alarming. In contrast, a fund exposed to one random factor boosts its performance by 163 basis points. With two random factors, this increases to 334 basis points, and with three, the result is even better – annual outperformance of 353 basis points. This demonstrates that diversification over several factors also pays off.
If you are an active manager who does not follow a factor-investing strategy you have a 20% chance of outperforming. If you invest in one random factor this figure increases to 51%, three random factors and your chance of outperformance will increase to 80%. This means with the right factor and the right manager, the chances of outperformance could be even higher!
The arguments for applying factor-based strategies are compelling. This research shows that if you adopt a conservative approach, select a diversified range of factors and carefully implement your strategy to avoid excessive costs and unrewarded risk, factor investing is a highly effective tool for enhancing returns. Can you afford to overlook it?
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