A large number of long-only multi-factor strategies have performed disappointingly over the past three years. Some have called into question the usefulness of solutions based on factor diversification but recent research by EDHEC suggests this doesn’t hold up against an even remotely serious investigation.
A large number of long-only multi-factor strategies have performed disappointingly over the past three years. This shift has led some commentators to call into question the very usefulness of solutions based on factor diversification, and notably the fact that the crowding effect was supposed to be the source of the disappearance of factor premia. However, we find in recent research that this suggestion does not hold up against an even remotely serious investigation. Rather it is the non-control of market beta exposure in a bull market context that has prevented factor indices from benefitting fully from the important market risk premium. It is this poor market conditionality, rather than variations in factor returns, that explains the recent disappointing performance of long-only factor offerings.
What are the drivers of the performance of factor strategies?
Commentators’ criticisms have tended to be based on assertions that have not been proven empirically, are not supported by serious academic research and ignore the very nature of factor strategy performance drivers. The latter is based on three main elements:
- Exposure to rewarded factors. While there are a large number of risk factors that can explain the variation in a stock or a portfolio of stocks’ returns over a period, there is a very limited number of factors that are considered to be rewarded in the sense that they not only have explanatory power over the variations in returns, but also explain the cross-sectional differences in returns of stocks or portfolios of stocks. These factors have been identified by academic research as being six in number, namely the value, momentum, size, low volatility, high profitability and low investment factors. The final two are often called quality factors.
- Good diversification of unrewarded idiosyncratic risk. Academic research shows that it is important for investors to strongly reduce idiosyncratic risks, those that are specific to each stock and which do not correspond to exposure to a systematic factor, because these risks are not rewarded. The usual way of reducing this in modern portfolio theory and construction is to diversify it. This allows the risk premia to be captured more efficiently.
- Management of systematic, non-factor risks. These risks are the undesired or implicit consequences of explicit choices of factor exposure or weighting schemes. When these implicit risk choices are not anticipated and controlled, they have significant consequences for the risk and performance profiles of factor strategies and can lead to strong differences in performance and risk for the same choice of factors over a given period.
These performance drivers have been the subject of many publications. However, one cannot but notice that in many critiques of the recent disappointing performance of factor strategies, they have been largely ignored in favour of highly-sample-dependent anecdotes and explanations that tend not to be based on rigorous observations.
Some of the explanations proposed were that some rewarded factors were no longer really rewarded (size) or that certain academic factor definitions were no longer appropriate (value) or indeed that the negative performance of factors was due to a crowding effect related to the very popularity of factor investing.
This is not the case. Rather, it is not the factors but the non-factor risks that are the source of the disappointing performance of the last three years. After analysing the performance of the factors and their consequences for the performance of a long-only multi-factor portfolio to place them in a long-term investment context, we will show the very simple impact of controlling or not controlling the non-factor risk to which all factor strategies are exposed, namely the market beta risk, on the performances of these same factor portfolios.
Performance and contribution of the factors
Within the US universe, three of the six long/short factors mentioned above have performed negatively over the past three years, namely size, value and momentum, and delivered much worse than the average negative performance observed since inception (21 June 2002). For momentum, this performance is even below its worst 5 per cent three-year rolling returns. For value, the performance is slightly above the worst 5 per cent and for size, the loss is close to the average of negative performance. On the developed ex-US universe the observation is quite similar.
However, in terms of both its value and its frequency, this negative performance is absolutely not abnormal and in no way constitutes a reason to call the premia associated with these factors into question.
With three factors out of six generating negative performance, it is expected that the analysis of the contribution of the factors as part of a multi-factor strategy will give mixed results. We therefore constructed single factor indices by using cap-weighted indices and adding a market-neutral long/short overlay and then built a multi-factor construction by aggregating these single long-only factor sleeves in the form of an equal-weighted six-factor index. This illustrated the previous results again, namely that three out of the six factors underperformed the broad cap-weighted index in the US region over the last three years, and three out of six in the Developed ex-US region.
However, if we instead use a perfect equal-weighted index, we observe that in both the US and Developed ex-US regions, this long-only factor construction outperformed the cap-weighted index over the same timespan (though admittedly to a lesser extent than over 15 years – 0.51 per cent compared to 2.45 per cent annual relative return for the US region and 0.55 per cent compared to 3.73 per cent for developed ex-US).
Hence, contrary to what is said by critics, a pure multi-factor construction continued to provide positive performance in the last three years.
It is therefore not so much the factors that are to blame in the performance but the construction choices of the multi-factor indices or portfolios offered by the providers. Among these design choices, some are constrained by the long-only regulatory framework of many funds or institutional investors. It is often difficult to set up pure factor strategies due to the inability to implement long/short strategies and the construction of long-only indices through the use of long/short overlays is difficult. Other choices correspond more to a lack of consideration of non-factor risks in the design of the index, where it involves documenting this risk in order to then manage it properly. In the next section, we will show that it is the lack of integration of the main non-factor risk that is the cause of the disappointment with factor strategies.
Integrating the contribution of non-factor elements into the performance of single and multi-factor indices
The vast majority of long-only factor strategies were rarely neutral from a market exposure viewpoint; market betas are generally defensive and unstable. For the same construction of long-only indices where, if instead of taking market-neutral indices we take long/short dollar-neutral indices, it is clear that over the last three years, these indices without market-beta control have considerably underperformed their equivalents with a market-neutral market beta long/short overlay. For the US, the 0.51 per cent outperformance over the past three years flips to an underperformance of -1.4 per cent, and to
-1.02 per cent from 0.55 per cent for the developed ex-US. For both regions, the long-only multi-factor assembly does not allow the broad cap-weighted index to be outperformed, as was the case previously.
It is therefore indeed the uncontrolled market conditionality of factors that, in a context of strong bull markets this year, led to disappointing performance, and not the choice of factors or the traditional proxies that represent them. Comparing the conditional performances of dollar-neutral long/short factors over 15 years illustrates this point well. It is easy to observe that in a context of strong bull markets, particularly in the US, the poor conditionality of dollar-neutral long/short was highly penalising compared to the market-neutral version.
In addition to design questions, performance is a matter of fiduciary choice
The analysis that we have conducted on the performance of factor and multi-factor portfolios has allowed us to observe that even though negative performance has been observed for some factors in recent years, it has been possible to offset this through the good performance of other factors. In the strict sense, the factor contribution to the performance of the strategies is not overall negative.
The source of the poor performance therefore needs to be sought elsewhere. We observe that only multi-factor indices which benefitted from a risk-control option that guaranteed alignment of the market beta with that of the reference cap-weighted index were able to significantly improve relative returns. Naturally, taking this market variation risk into account is a fiduciary decision that falls outside of the remit of an index provider, as long of course as the index provider offers these options, which is rarely the case.
Daniel Aguet, head of indices, Scientific Beta; Noël Amenc, chief executive, Scientific Beta and Associate Dean for Business Development, EDHEC Business School; and Felix Goltz, research director, Scientific Beta