Factor Investing Works (Despite What Some May Say)

Don’t fall for claims by highly respected asset managers that factor-based investing isn’t working. Factor-based strategies have outperformed capitalization-weighted indices over long time horizons.

The May 28, 2019, Institutional Investor article, Why Factor Investing Isn’t Working, began by noting, “Pension funds and endowments aren’t getting the factor premiums they desire – just uncompensated risk.” The article continued: “Asset owners have increasingly incorporated factor-based funds into their portfolios in an attempt to earn equity premiums at a low cost. But they are ending up bearing currency, country, sector, and other risks that are going uncompensated, according to an analysis of 500 complex institutional portfolios by Northern Trust Asset Management.”

The article went on to note that Northern Trust’s study “found that institutions weren’t getting the results they wanted for a number of reasons. First, targeted factor exposures are being offset by the other managers held in asset owner portfolios, creating index-like outcomes at higher fees. Second, many endowments and retirement plans have invested in poorly designed factor-based funds, which don’t efficiently deliver the premiums that investors are counting on.”

Over my long career, I have seen many examples of this behavior. For example, I’ve seen pension plans that have owned both a Russell 1000 Index Fund and a Russell 2000 Index Fund. The more efficient way is to own the Russell 3000 Index Fund, avoiding turnover as stocks migrate from large to small and vice versa. I’ve also seen them own both growth and value indexes, in effect recreating the total market but incurring higher expense ratios and the costs of turnover due to stocks migrating from growth to value and vice versa. The explanation for the behavior is that those investors are diversifying in a sub-optimal manner, merely filling in the Morningstar-style boxes.

Yet another reason for the failure of pension plans to benefit from factor exposures is the short horizons they use to judge performance. While many pension plans evaluate performance over three- to five-year periods, financial economists know that when it comes to judging the performance of risky assets (or factors), even 10 years can be nothing more than noise. Because of their short horizons, many pension plans buy after periods of strong performance (at higher valuations and thus lower expected returns) and sell after periods of poor performance (at lower valuations and higher expected returns). In fact, the evidence we have from studies such as the 2008 paper, The Selection and Termination of Investment Management Firms by Plan Sponsors, by Amit Goyal and Sunil Wahal, demonstrated that the managers pension plans fire go on to outperform their replacements. If plan sponsors had stayed with the fired investment managers, their returns would have improved! The lack of discipline leads to underperformance.