The best minds in investing agree on one rather downbeat conclusion: Returns over the next decade are likely to be less generous than the ones we have enjoyed over the past decade.
This is not pessimism. It is just reality. At current yields, bonds generate very little payoff once you account for inflation. Stocks may still have room to rise, but after several years of mostly good performance, it is difficult to argue they are exceptional bargains, especially after the sizzling returns of the past month.
So what is an investor to do? One answer is to consider what is known as factor investing. It promises to help people do better than the overall market and is being heavily promoted as a strategy by several fund companies.
The basic idea behind factor investing is to buy stocks with features that have led to high returns in the past. For instance, stocks that have fallen to unusually cheap levels in relation to their earnings and balance sheets often go on to produce big payoffs for investors. Value investors have known about this tendency for generations.
Other factors are less well known. The momentum factor, for instance, refers to the tendency of stocks that have risen strongly in recent months to go on rising for a few more months. In contrast, the low-volatility factor recognizes the surprisingly strong results produced by the most stable stocks.
Researchers have claimed to discover hundreds of potential factors lurking in the market data. In fact, if you’re fond of watching wonks battle, it can be oddly entertaining to follow along as academics debate which of these anomalies deserve to be admitted to the factor royalty and which are just pretenders. It’s a bit like listening to hockey fans debate which players belong in the Hall of Fame.
A recent paper from a trio of Dutch researchers attempts to put the factor feuds into perspective. Guido Baltussen and Laurens Swinkels of the Erasmus School of Economics in Rotterdam and Pim van Vliet of Robeco Institutional Asset Management looked at two centuries of market data to see whether some of the most popular factors are as strong as their supporters would like to believe.
By and large, the researchers find they are. Value and momentum factors have a long record of success as does low volatility. So do other factors such as seasonality – the tendency of individual stocks or other assets to have better returns in some months than in others.
These factors haven’t worked each and every year, but by and large they have demonstrated their ability to beat the market in different eras, in different countries and across different types of assets. The results from two centuries of evidence “reveal consistent and ubiquitous evidence for the large majority of global return factors,” the researchers say.
This is fascinating. It is also alluring. But what does the strong showing of factor investing throughout history mean for individual investors?
This is where things get tricky. Providers such as Vanguard, iShares and Fidelity now offer a multitude of funds that attempt to capture factor-based payoffs. You can buy low-volatility funds, value funds, momentum funds and so on. Many of these products deserve a close look, especially if you are particularly fond of betting on a single factor.
However, investors should put realistic limits on their expectations. While the academic research on factors yields impressive results, the reality on Main Street can be much less grand, according to Nicolas Rabener of FactorResearch in London.
The discrepancy reflects structural factors. Researchers usually attempt to measure the strength of a factor by looking at what would have happened if you had constructed a portfolio by purchasing the stocks with the highest level of the factor in question, while simultaneously selling stocks with the lowest levels of that same factor.
In market jargon, these are known as long-short portfolios because they combine “long” positions (where you bet on something going up) and “short” positions (where you bet on something going down). For instance, a value portfolio in academic research will do two things – go long on cheap companies and go short on expensive ones.
This is fundamentally different from what takes place in most factor-based products available to the public. These products typically only go long on stocks with a high level of a given factor. They don’t short stocks with a low level of that factor.
Furthermore, these funds face transaction costs that academic researchers don’t encounter when building hypothetical portfolios. The combined drag from those real-world costs, plus the lack of any payoff from short positions, means many retail investors are likely to get only part of the extra return promised by factors in the academic research, Mr. Rabener writes.
Investors should keep this in mind. In a low-return world, factor investing offers a realistic hope of doing somewhat better than the market. But the results may not be quite as spectacular as the hype suggests.