Do Implementation Costs Destroy Returns from Factor Portfolios?

Do factor premiums survive implementation costs? To answer this question, I’ll examine the returns of live mutual funds to see if they have been successful at capturing the returns of small-cap and value premiums.

As background, my book, Your Complete Guide to Factor-Based Investing, includes a checklist of criteria that should be met before you consider investing in a factor. For a factor to be considered, it must meet all of the following tests. To start, it must provide incremental explanatory power to portfolio returns and have delivered a premium (higher returns). Additionally, the factor 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 price-to-book, earnings, cash flow or sales).
  • 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.

This article focuses on the question of investability and implementation costs. We’ll begin by examining the size factor – a logical place to start because small-cap stocks are less liquid and thus potentially more expensive to trade. Is the size premium realizable – or does it just exist on paper? Let’s start by examining the returns of small-cap mutual funds.