Investing in a market where people believe in efficiency is like playing bridge with someone who has been told it doesn’t do any good to look at the cards. – Warren Buffet
As Wesley Gray, PhD of Alpha Architects has summarized, “Factors are everywhere.” A factor is a characteristic that explains stock returns. The concept of Factors has been around since Eugene Fama and Ken French began developing statistical models to explain stock returns relative to the broader market. Since their initial work, more and more factors have been added, and just in the past few years the idea has exploded in popularity, with so called “Smart Beta” funds (another term for Factor based investing) sprouting up everywhere one looks. Yet despite the newfound popularity and hype for this investing approach, very few of these Factors withstand academic scrutiny.
Academically speaking, a Factor provides explanatory power to portfolio returns that have delivered a premium (higher returns). As The Complete Guide to Factor-Based Investing describes, it also 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 (for example, there is a value premium whether it is measured by P/B, P/E, P/CF, or P/S).
- Investable – It holds up not just on paper, but also 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.
Academics construct Factors as a long/short portfolio, typically dividing their investment universe in thirds (for the Size Factor for example, the portfolio is long the smallest third of stocks, and short the largest third of stocks). In practice though, Factor based investors (like HCM) use long only portfolios, which means it is even more important to use the best definition for a Factor (for example, using EV/EBITDA or EV/EBIT instead of P/B for Value, as we will discuss later).
So why do some Factors work? The traditional finance perspective holds there should always be a risk-based explanation for additional returns (more reward requires more risk). However, there are two other primary reasons: they can be founded on deep seated psychological biases of investors and, ironically, they can go through long stretches of underperformance. Take the Value and Momentum factors as an example.
One of the major behavioral biases explaining Value and Momentum is the tendency of investors to overreact to bad news and under react to good news over the medium-term. Overreacting to bad news punishes a stock’s price beyond reasonable valuation, resulting in significant opportunities for savvy investors looking for bargains. And underreacting to good news means that a company whose stock price has done well over the last 2-12 months will usually continue to rise.
However, both Value and Momentum investing have seen significant stretches of time where they have underperformed the broader market. Take Momentum (charts provided by Alpha Architects):
This looks like (and is) an excellent track record over the long run. However, as the following graph illustrates, the overwhelming long term performance masks periods of significant underperformance that can span more than a decade.
The same story can be told with the Value factor (the blue line going down indicates times when Value outperforms Growth):
Again, while over the long run Value significantly outperforms Growth (and the broader market), there are painful periods. However, like Momentum, it is these periods of underperformance that secure long run outperformance. Many investors and portfolio managers can’t stomach short-term underperformance, thereby ensuring that overvaluation of a factor – which then leads to subsequent underperformance – is temporary and maintains the long term viability of the factor. Further, these periods of underperformance highlight the importance of constructing portfolios that diversify across factors, so underperformance in one factor does not hamper the entire portfolio. Here are the major academically accepted Factors, many of which HCM utilizes:
- Low-volatility
- Size
- Value
- Momentum
- Quality (Profitability/Investment)