Debunking five common myths about factor investing

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This is a sponsored article from Vanguard.

The investment world has embraced factor-based strategies in recent years as their popularity has soared and a rapidly growing and diverse array of product offerings has emerged.

As the range of offerings expands, however, so too does the number of myths and misconceptions surrounding factor-based investing, not least because of the lack of clear definitions. Different investors have different interpretations of how factors are identified and they may have a different understanding of how factors have performed historically or on how to approach multifactor strategies.

Vanguard – one of the biggest players in factor investing servicing more than 20 million clients worldwide, including large institutions and banks – has drawn on its extensive expertise to cut through the clutter and debunk five common myths about factor investing.

MYTH 1: All documented factors are good factors
REALITY: Currently, there are more than 300 documented factor characteristics but not all of them benefit investors and therefore cannot be described as good factors. To qualify as such, a factor must meet three central criteria:

  • A factor must display an enduring, logical rationale for investing either on a risk-based or behaviour-based basis.
  • A factor’s investment potential must be supported by solid empirical evidence such as out-of-sample tests or academic studies.
  • A factor must be investable and the reward must be worth the risk once implementation costs are taken into account.

Based on these three core principles, Vanguard focuses on five of the best-known factors: value, momentum, quality, liquidity, and minimum volatility — all of which meet or exceed the criteria and have demonstrated outperformance historically. Investors still need to do their due diligence on not just why a factor worked in the past but whether it has good rationale to work in the future.

MYTH 2: Factor investing can be timed
REALITY: In factor investing, outperformance and underperformance both occur periodically across different market cycles.

Like other forms of active management, the performance of equity factor tilts relative to the broad market is difficult to predict, particularly in the short term. Since the relative performance of equity factor tilts varies over time, it is difficult to profit from these swings through market timing. As the wide performance dispersion indicates, a high degree of uncertainty is associated with the relative performance of equity factor tilts in any particular market, economic, and monetary policy condition (Chart 1). The challenge of forecasting what the environment will be, when it will occur, and how factors will act as a result is notoriously difficult. Using factors successfully requires discipline and a degree of flexibility.

Chart 1: Performance in different environments has been unpredictable

Value factor tilt (1975-2016)

Notes: Excess returns are annualised and are calculated relative to the MSCI World Total Return Index (USD). All results are as at 30 September 2016. MSCI World Value Index (USD) is from 31 December 1974 to 30 November 1997 and MSCI World Enhanced Value Index thereafter. To define early and late recession, we divided each historical recession in half. The 12-month period before a recession was defined as late expansion, and the 12-month period after a recession was defined as early expansion. We used the data for US recessions from the National Bureau of Economic Research. Bull markets were defined as continuous periods without a broad equity market decline of more than 20%. Bear markets were defined as periods when the market fell at least 20%. Fed easing was defined as periods that included three consecutive reductions in the US federal funds target rate. Fed tightening was defined as periods with three consecutive increases in the target rate. Sources: Vanguard calculations, using data from Thomson Reuters Datastream, MSCI, and Bloomberg.
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MYTH 3: Factors will always outperform
REALITY: Even factors with the greatest historical performance and the strongest rationale for future expected performance can go through significant periods of underperformance. For example, each equity factor amongst value, size, momentum, quality, liquidity, and volatility has underperformed by at least 7 percentage points relative to the broad market over a 12-month period, potentially challenging the conviction of even the most patient investors to stay the course.

Investors have tended to sell active investments that underperform over shorter periods, but expectations need to be tempered with a long-term focus. It is therefore critical for investors to decide in advance if they have the willingness, ability, and time horizon to cope with inevitable periods of relatively poor performance.

MYTH 4: Using multiple factors dilutes potential performance
REALITY: While using multiple factors seldom leads to absolute top performance, combining factors with low correlation of excess returns provides a smoother ride through diversification and market turbulence while maintaining the ability to capture potential excess returns over time and improve risk-adjusted returns.

Given the significant active performance cyclicality of single equity factors, the diversification benefits associated with multiple factor tilts have historically been reasonably strong as the active risk can potentially be reduced by holding a combination of factors.

MYTH 5: A top-down approach is the only strategy for multifactor investing
REALITY: The most appropriate approach for each investor should be based on their individual objectives, constraints, preferences, due-diligence capabilities, and belief sets.

In the top-down approach, factor exposure is determined via vehicle selection, with each vehicle targeting a specific factor. This gives the investor flexibility to decide which factors to include in each vehicle and their weighting, the asset manager for each factor, as well as the allocation of each single-factor vehicle.

By contrast, according to the bottom-up approach, factor exposures are determined through security selection, with portfolios based on the combined factor exposures of individual stocks. A stock with a moderate sensitivity to several chosen factors is more likely to be selected in a bottom-up portfolio than a stock with a high sensitivity to just one factor but poor sensitivity to the other(s). This approach ensures chosen stocks are not inadvertently tilted against any of the targeted factors.

While research shows that both multifactor approaches exhibit historical outperformance, the bottom-up approach has tended to produce better long-term results for investors who plan to hold their factor exposures for a longer period.

Not all factors are created equal, but by cultivating discipline, flexibility, and enough patience to stay the course, investors can increase the potential for excess returns over the long term with factor usage.

For more on factor investing, visit www.vanguard.com.hk/factor investing.

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This is a sponsored article from Vanguard.

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