Like many folks these days, I rely on the interwebs to discover how to do certain things. Change the battery in my home alarm system? YouTube. Learn how to create a smokey eye? Instagram. Grill a turkey for Thanksgiving dinner? Jimmy-D’s Thanksgiving Turkey BBQ 2010.
Of course, these efforts are met with varying degrees of success. My recent foray into alarm-battery changing resulted in an unplanned visit by Nashville’s finest. All attempts at a smokey eye were followed by offers of domestic abuse support and/or temporary blindness. In fact, only the turkey grilling turned out the way I’d hoped, since the meal was both edible and guests remained salmonella-free.
It’s not just me. Lots of people think that mimicry is pretty easy. In fact, there are whole websites and videos devoted to cake disasters (can you even tell that’s supposed to be a Mallard Duck Birthday Cake I baked for a hunting friend of mine???) and other sites where people can post DIY fails for your enjoyment and moment of daily schadenfreude.
And of course, the investment industry can’t be immune to these sorts of shenanigans - we just aren’t that special. But in the case of investing, we usually refer to our attempts at mimicry as factors, and although we label these “smart beta,” in fact success rates can be just as varied.
Indeed, factor investing has become incredibly commonplace during my tenure in the investment industry. These days, I think I hear the words “well, couldn’t you just use the [value, quality, momentum, size, low vol, or any number of the other 300-plus] factor instead and do it for [5, 10, 20…] basis points?” in my sleep. The word “factor” has even started reverberating through my head sometimes like a Jan Brady “Marcia, Marcia, Marcia” redux.
Call me contrary, but any time an investment theory (or really any trend) is thrown around with this much impunity, it makes my Spidey senses tingle. Is it really possible that all investing can be boiled down to choosing the “right” factors and that generating returns can be so simple and cheap?
It turns out, maybe not. I read an interesting paper the other day, “Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing” (Arnott, Harvey, Kalesnik and Linnainmaa, 2019) that theorized that factor investing may actually underwhelm due to problems with data mining, crowding, trading costs, diversification and other issues that make it less than the “perfect” return generator it’s often mistaken for.
What’s more, because most factors are backtested over a long period of time (standard investment industry protocol, right?) there is a bit of smoothing that may be evidenced by the final factor-based product. In the paper, the authors highlight the performance of 14 popular factors from July 1963 to June 2018. During that period, the value factor exhibits negative correlation to the markets. So, one might believe that value is a diversifying factor in a portfolio. And it may be. Until it ain’t. “The value factor, for example, typically correlates negatively with the market. The paper actually concludes that “[d]uring the global financial crisis, however, the value factor correlated positively and significantly with the market, performing poorly as the markets tumbled and soaring as the stock markets rebounded.”
Huh. Whoda seen that coming?
I already had my suspicions about this prior to reading this paper, however, although they were admittedly less academically rigorous. These misgivings began to take root when factors became the quick answer for everything. Like a manager’s strategy? Let’s figure out the factors and do it cheaper! It’s esoteric? There’s still gotta be a factor we can use. Oooh…here’s some correlation in a single market environment – that will be perfect!
Look, I know that active management has taken it on the chin during this 150-plus month bull market. I understand that investors are increasingly price sensitive and replicating strategies on the cheap has great appeal. I even get that, at this moment in time, when a strategy may be highly correlated with a particular factor (perhaps because both are trending up), that factor investing may look too good to pass up.
But I do wonder, when the markets get tested and everything turns ass over elbows, whether we’ll be eating the perfectly grilled turkey I learned from Jimmy-D or that sad, parrot-looking mallard cake, complete with (no joke!) red velvet sponge. If you’re not at least wondering a teeny tiny bit the same thing, perhaps I need to ask Jimmy-D to host a video blog for us on the topic.