Drawn by the prospect of market-beating returns, in the last 15 years many individual investors and institutions have been disappointed by their returns from factor investing.
In his latest research, Campbell Harvey – a finance professor at Duke University’s Fuqua School of Business – explored the causes of this disappointment in a strategy that picks investments based on a spectrum of attributes associated with strong performance in the market.
Co-authored with Juhani Linnainmaa of the University of Southern California, plus Vitali Kalesnik and Robert Arnott of Research Affiliates LLC, Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing describes three mistakes factor investors are commonly making.
Mistake #1: Grossly exaggerated expectations of return
Harvey said investors are too reliant on factors that are backtested – using past performance to predict future return. In his research, Harvey has documented more than 400 factors that have been published in top journals.
“There’s a massive amount of data mining going on,” he said. “Data mining can find things that appear to work when in reality they don’t. It’s no surprise that with a very good backtested return, you develop an exaggerated expectation of a future return.”
Also, factors that are successful attract the kind of attention that diminishes their market-beating potential.
“As more people pile into these factors, prices are driven up and expected returns are driven down,” Harvey said. “This is the typical result of what’s known as crowding.”
Investors also fail to account for the high transaction costs involved in factor investing.
“In academic literature it’s routine to assume transaction costs are zero, and that’s not the real world,” Harvey said. “For example, the cost of short-selling a small-cap investment is enormous, and often it’s assumed to be zero.”
Mistake #2: Naïve risk management assumptions
Many investors believe factors are normally distributed, meaning that on average they carry roughly the same risk as the rest of the market.
“Well, they aren’t,” Harvey said. “Not even close.”
Harvey and his coauthors explored the distributional characteristics of factors and they have what investors call very substantial negative tails – a risk that the investment will decrease in value beyond normal limits – leading investors to be surprised.
“These tails need to be taken into account,” Harvey said, “and routinely, they’re not.”
Mistake #3: Misplaced confidence in a “diversified” portfolio
Investors may see the first two mistakes and think they are protected because they have a portfolio of factors and are thus diversified, Harvey said.
“That’s a false assumption,” he said. “For certain variables, there’s some reason to believe that if you add them together into a portfolio that they’ll be better behaved, but that’s not the case with a portfolio of factors. When you really need diversification, in a crisis situation, that’s exactly the time when the diversification among factors vanishes.”
Ultimately, factor investors need to educate themselves so they understand what they’re getting into, Harvey said.
“If you’re going to pursue factor investing, you need to understand the process and the limitations,” he said. “You need to develop reasonable expectations of what you will get factor by factor, and portfolio by portfolio. This is a very difficult business, and if you start off constructing your portfolio with naïve assumptions then you’re asking for trouble.”
The paper can be downloaded here.