Written by: Yazann Romahi , Chief Investment Officer, Quantitative Beta Strategies; Joe Staines , Research Associate, Quantitative Beta Strategies; Garrett Norman , Beta Specialist
The rise of factor investing has sparked excitement as well as angst across the investment community. As these strategies have become increasingly popular, investor enthusiasm has been coupled with questioning as market participants look to understand how the dynamics of factor investing might change over time.
Among the questions investors are asking:
We begin with a few basics. We define a factor as any characteristic that describes the risk of a group of securities or financial instruments. Exposure to a factor based on an economic rationale should reward (or compensate) an investor (Exhibit 1). Compensated factors fall into three overlapping categories: risk-based (such as size, merger arbitrage) behavior-based (momentum, quality) and structural-based (low volatility, index arbitrage).
The effects of investor crowding
At any given point in time, investors may crowd into a factor, eroding future returns. For example, the quality factor reflects the notion that high quality stocks tend to outperform low quality stocks. But crowding in high quality stocks can result in the factor getting squeezed to the point that the valuations of high quality and low quality stocks may be quite similar (Exhibit 2).
In the short term, then, crowding can make a factor expensive. However, once the factor becomes expensive and goes through a period of underperformance, investors will de-allocate and the factor will re-assert itself in a manner similar to the cycles of equity market richness/cheapness. In other words—and this is key—crowding cannot arbitrage out a compensated factor’s returns over the long term. Exposure to factors backed by solid economic rationale (risk-based, behavior-based or structural-based), and empirically proven to compensate investors across a range of time periods, geographies, and asset classes, should reward investors over time.
The case against factor timing
Because individual factor performance can be very cyclical, investors may be tempted to time their factor investments with an eye to minimizing drawdown. Here we sound a few notes of caution. First, we have discerned only a weak relationship between valuation spreads and subsequent factor performance. The relationship between the business cycle and subsequent factor performance is tenuous as well. Second, the transaction costs of timing can be considerable.
Finally, a fundamental drawback of factor timing is that it reduces diversification, whose benefits are especially powerful when return sources are uncorrelated. For all these reasons, we take a cautious stance on timing factors systematically, although we do see potential for an approach that combines qualitative insights and quantitative inputs.
The future of factor investing
We believe that factors will provide persistent sources of return over time. However, we acknowledge that as factors become more accessible and factor strategies are used by an expanded range of investor types, the dynamics of factor investing may change in three important ways.
Cycles may become more frequent: Because investors can now access a wide range of factors, in vehicles that offer daily or even intra-day liquidity, the cycles between factor richness and cheapness may compress as capital chases after performance. Factor cycles may increase in frequency, leading to higher volatility.
Correlation between factors may increase: As factors become more frequently used in multi-factor strategies, they may be impacted by investor inflows/outflows in a more uniform fashion, potentially increasing correlation between factors. As yet this dynamic has not played out. For example, during the February 2018 market selloff, factors behaved independently and correlations did not dramatically increase.
Correlation with risk assets may increase: In an effect that can be deemed a curse of liquidity, as factors become more popular, on a short-term basis they may begin to trade more in line with traditional risk assets. The curse of liquidity can play out in different ways. In times of broad market stress, investors may decide to sell all their risky investments, including their factor holdings in that category. On the other hand, if factors hold up well in times of broad market stress, investors may source capital from factor strategies to meet liquidity needs. But, again, it’s a short-term phenomenon. Over the long term, we believe, the factor’s diversification benefit will endure even as it may appear to decrease over time when gauged by short-term metrics.
In conclusion, we reaffirm our first principle of factor investing: Factors backed by an economic rationale will be robust enough to handle investor crowding, offering returns that will persist over the long term. While the idea of factor timing may be tempting, we do not believe the approach is reliable on a systematic basis. What is reliable in factor investing? The proven value of diversification over time.
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