The Brutal Truth About Factor Investing

Active management loses again. 

Asset managers can generate higher returns by using market timing factors, such as value or momentum, than they can with a passive, equally weighted equity factor portfolio. But in the end the costs of turnover and transaction fees significantly eat into the potential returns, eliminating the benefit, according to a paper published Monday in the Financial Analysts Journal. 

The findings provide reason for investors to be cautious about dynamic equity factor allocation compared with the simpler strategy of constructing a passive multi-factor portfolio, according to a companion publication summarizing the paper. 

The findings of the FAJ paper, entitled “Optimal Timing and Tilting of Equity Factors,” come as asset managers are racing to offer multi-factor funds that are actively managed in a bid to build interest in active strategies while taking advantage of the growing popularity of factor funds.

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Harald Lohre, one of the authors of the study and a senior research analyst on the quantitative team at Invesco in Frankfurt, told Institutional Investor that there is meaningful predictability about future performance when looking at standard factors, such as value and size. But once academic factors were replaced with investable global equity factors or indexes, the practicalities of implementation started taking their toll. 

“We find when we switch to a realistic setting, predictability is hard to enjoy after transaction costs. The alpha is eroded because of costs,” said Lohre, who is also a fellow at the Centre for Financial Econometrics, Asset Markets and Macroeconomic Policy at Lancaster University Management School in the U.K.

Lohre initially looked at the issue to determine whether Invesco could profitably time factors for clients. “Can we add additional value to a multi-asset portfolio by dynamically switching from one factor to the next?,” he said. Invesco is sticking to portfolios, at least for now, that only strategically allocate between asset classes. 

The researchers found that a factor-timing strategy had gross returns of 4.17 percent annually over 20 years. That is 0.95 percent higher than what a passive, equally weighted benchmark returned.

The factor-tilting strategy only improved on a risk-adjusted basis when the researchers used a short-term momentum factor. Factor tilting is essentially looking at “factors within factors,” or characteristics of the factor that can be emphasized or de-emphasized at different points in the cycle. 

But the turnover of the fund and high costs of transactions ate away much of the potential return of both timing and tilting portfolios, according to the FAJ paper.

Lohre said that after he presented the paper at a recent quantitative investment conference in London showing that timing and tilting factors didn’t yield better results than sticking to a strategic allocation, an attendee sitting in the front row offered a telling comment during the question-and-answer session that followed.

“I’d like to thank the presenter for his honesty," Lohre said the man told him. 

For asset managers looking for a way to differentiate themselves from all the other competitors offering factor-based funds, it’s hard to hear that active management of factors doesn’t yield much, explained Lohre, one of five researchers on the paper. 

“So many people approached me after the discussion. All have tried their hand at this and some are bold to put out positive results,” he said. “But the industry knows it’s very hard — and [they] should be cautious, and perhaps timid, with factor movements.”