Stop Blaming the Factors, Scientific Beta Says

The investment factors aren’t to blame – it’s your selection of them that needs work, according to Scientific Beta. 

New research from the EDHEC Business School unit found the underperformance of factor strategies over the last three years could have been offset through better decision-making surrounding investors’ exposure to various characteristics of stocks. Scientific Beta’s Noël Amenc, Daniel Aguet, and Felix Goltz wrote about their findings in a paper released Tuesday. 

“Contrary to what has been affirmed without any really serious study or even rigorous empirical observations, the poor performances of multi-factor indices or solutions are not the result of a strong and abnormal deterioration in factor performances,” Amenc, chief executive officer of Scientific Beta, said in a statement. “One can certainly observe that some factors have experienced significant underperformance, but it has been possible to offset this with the performances of other factors.”

Index and strategy design of long-only strategies rarely considers the risks caused by factor exposure choices, according to the paper. The authors said that “market beta” risk has the biggest impact on returns and volatility over the longer term, yet it is the least controlled. 

Factor diversification in the long-only context is typically done with pure, long-only single or multi-factor portfolios that naturally embed “market beta deviation,” according to the paper. The authors said that a vast majority of multi-factor strategies are built with “defensive beta biases.” 

“It is clear that the pronounced bull market conditions of the last 3 years, notably in the U.S., have been unfavorable for multi-factor indices or solutions,” Amenc, Aguet, and Goltz wrote in the paper. “In this context, only multi-factor indices that 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.”

[II Deep Dive: Rob Arnott: Avoid These Blunders in Factor Investing]

Market variation risk falls beyond the remit of an index provider, leaving investors to make fiduciary decisions based on their risk and return objectives, according to the paper. For example, an investor seeking lower volatility than the market, and better performance in bearish times, should rule out the market beta adjustment, the authors suggested.

“Stock picking is not a robust way to deliver risk-adjusted outperformance,” they said. “Giving serious thought to managing the risks of factor strategies... is what really matters.”