Ignored Risks of Factor Investing

Key Points

  • The risks of factor investing are usually understated (perhaps, severely so), and the diversification benefits tend to be overstated.
  • Because factor returns substantially deviate from normality and because correlations between factors are not constant over time, a multi-factor portfolio may retain exposure to the risk drivers of the individual factors. Thus, portfolios invested in multiple factors may still experience severe drawdowns and decade-long periods of underperformance.
  • Factor investing, for patient investors who understand the risks, has the potential to improve a portfolio’s long-term risk-adjusted return, especially when strategies used are transparent, use sufficiently researched factors, and have low management fees and good implementation characteristics.

Factor investing, an investment approach which targets specific stock characteristics such as value or momentum, is becoming a stronghold of investor portfolios.1Many factor-investing strategies are popular for good reason: they are transparent, offer exposure to widely agreed-upon sources of expected return, have low management costs and, with proper design, reasonable transaction costs. Of course not all products in the category provide all of these features. When these features are present in a strategy, however, the strategy has the potential to generate a substantial positive impact on investor returns.

Product providers blithely advertise the benefits of factor investing, touting the strong long-run (usually backtested) value-add of individual factors, the manageable tracking error, and the low average correlations of most individual factors. The usual factor-investing sales presentation leaves an impression that investing in factors means almost guaranteed excess returns and that investing in a number of factors eliminates most of the risks of underperformance as a result of diversification. The standard disclaimer that follows the presentation cautions past performance is not indicative of future returns, the excess return is not guaranteed, and so forth, while offering little information about the specific dangers of factor investing. The combination of positive messaging in presentations with easily overlooked or disregarded disclosures means that investors too often ignore, and thus do not prepare for, the risks that come with factor investing.

Not fully understanding the myriad risks that lie ahead in the investment journey, investors are likely to make poor choices about when to begin and end their investment in a particular strategy. Entering at the wrong time, or missing a few market turning points, can mean the investor is ultimately a net loser in factor investing. Factor investing can be a very useful tool, however, to help investors enhance their return and make prudent investment choices if they do so with full knowledge of the strategy’s potential risks.