Equity investors in search of higher returns are increasingly turning to factor investing. Driving this trend is frustration with the underperformance and higher fees of traditional active equity approaches, along with a growing realization that many stock-picking strategies owe their results largely to the manager’s factor tilts rather than stock-specific risk. So, the reasoning goes, why not gain exposure to these return drivers more cost-effectively and transparently with factor strategies?
Indeed, factor investing may very well be the new active equity, providing investors with exposure to the characteristics of stocks that tend to be associated with higher returns and offering the potential to outperform passive indexes. But how should investors navigate the increasingly crowded factor and smart beta landscape? We think evaluating factor-based strategies boils down to three key considerations.
1. Ensure factors are robust. With the rising popularity of factor investing, the number of factors linked to excess returns seems to grow each day. Unfortunately, many of these factors have been data-mined, so it’s difficult to determine whether they could offer a persistent source of long-term excess returns. In fact, we believe the number of factors that are grounded in academic literature and offer a sound rationale for long-term outperformance potential is quite small. Managers who construct factor portfolios often use rigorous quantitative processes to determine their robustness, but as an investor, we suggest asking two simple questions:
- Why should this factor work in the future?
- Who is on the other side of the trade?
The answers to these questions should offer a risk-based or behavioral explanation as to why a factor should be a source of future excess returns as well as an intuitive rationale as to why those return premia should persist.
2. Pay attention to valuations. With factor investing, as with any investment strategy, valuations matter. Just as asset classes, sectors and individual stocks can get rich (“expensive”) or cheap and experience mean reversion, so too can factors. For instance, as the chart below shows, the low volatility factor appears expensive today relative to its historical range, while the value factor is relatively cheap. The risk to investors is that choosing a strategy focused on expensive factors, which may indicate a crowded trade, may reduce future return prospects. Diversification across factors is an important way to address this risk, so multi-factor strategies may be an attractive solution. So too are strategies that incorporate factor valuations into their process, for instance by dynamically weighting factors to favor those that look more attractive on a forward-looking basis.