Andrew’s Angle

Fending off factor investing fallacies

Andrew Ang, PhD |Sep 24, 2019

The capacity of factor strategies appears large 

Until investors are no longer risk averse, markets have no more structural impediments, and humans generally stop acting like humans, factor premiums should continue
to persist.

The earth is round.

In truth, the earth isn’t a perfect sphere (it has flattened North and South Poles), but the earth positively, absolutely, certainly is NOT flat. We’ve known this at least since 240 BC when Eratosthenes, a Greek astronomer, used science and mathematics to demonstrate the curvature of the earth.

But still, there are some people, and even a Flat Earth Society, who are unconvinced despite thousands of years of irrefutable scientific evidence.

In finance today, despite the success factor investing has exhibited, there are skeptics who are dismissive. A recent article in the Economist suggested that with the rising popularity in factor-based strategies, perhaps investors should question their continued success. In my letter to the editor published in August (available online), I stated my case for continued faith in factors. It reminded me the world is full of misperceptions: let’s take the opportunity to refresh investors on the basics of factor investing and why factor premiums exist.

What is and isn’t a factor?

Factors are broad and persistently rewarded drivers of return. Macro factors like economic growth and inflation affect many different asset classes. Within an asset class like equities, thousands of stocks have exposure to style factors like value, momentum, and quality. The long-run returns to macro and style factors have been exhibited for centuries, and academics have studied them for decades.

Macro and style factors

Macro and style factors

Source: BlackRock, as of August 31, 2019

Yet, the number and nature of factors continues to be debated.

To distinguish between factors that are a passing fad versus those that are fundamentally based and rigorously established, we focus on four key criteria:

  1. The factor has a solid economic rationale for a return premium, based on intuition and supported by academic evidence to support the factor
  2. We have empirical evidence, spanning decades and even hundreds of years, that the factors have exhibited positive premiums
  3. Factors offer differentiated returns and diversification benefits, with low correlations between the different factors
  4. We can harvest factor premiums in a transparent and repeatable way, passing on low costs to investors

Only a handful of factors rise to meet these four simple criteria. The three most important macro factors are economic growth, real rates, and inflation, which explain approximately 85% of variation across asset classes1. In equities, there are five factors: value, quality, momentum, size, and minimum volatility.

While it’s possible that today’s research could uncover new factors, our research is focused on more novel ways to express classic investment ideas – thinking critically about how to define and express what’s cheap, what’s trending, and what’s high quality, for example.

Why do factor premiums exist?

This is the most important question and is the crux of the first criterion listed above. A large body of academic work—including six Nobel prizes—have shown that factor premiums arise due to enduring economic phenomena:

  1. Rewarded risk – some factors have earned higher long-term returns to compensate investors for taking on more risk.
  2. Structural impediments – market rules or other constraints can place restrictions on certain large investors. Those off-limits investments can become opportunities for others.
  3. Investor biases – investor behavior is not always perfectly rational, giving rise to mispricings.

Let’s put a few style factors to the test.

Momentum investing takes its roots from trend-following strategies dating back decades, and some would say centuries. Momentum can arise due to slow dissemination of firm-specific information, and the delay in price reactions causes trends.

Minimum volatility, on the other hand, can come from some investors over-weighting high risk stocks in an attempt to meet high return targets. They under-weight low risk stocks, with prices being driven down for more stable stocks that allows for higher risk-adjusted returns.

And the list goes on.

Factors are cyclical

While in the long run style factors have demonstrated a significant premium over broad markets, we don’t expect every factor to have a positive return every month or every year.

Over the short term, factor returns vary over time. Taking exposure to several factors in a strategic allocation – through a multi-factor strategy for example - may provide a more consistent return experience.

In particular, the value factor has exhibited poor performance since the end of 2017. This underperformance is consistent with the economics – as I’ve written about previously, value stocks tend to perform best during the early stage of a business cycle and we have been in a prolonged late stage environment. On the other hand, minimum volatility has done well in 2018 and year-to-date in 2019. Some investors may consider aiming for additional returns by tilting factor positions across the business cycle.

Keeping the factor faith

Until investors are no longer risk averse, markets have no more structural impediments, and humans generally stop acting like humans, factor premiums should continue to persist. Factors can continue to endure because investors receive long-term rewards for taking certain risks. Those risks require patience and the ability to endure potential losses during short-term periods, but this creates opportunity to add potential incremental returns by actively tilting factor positions across time.

Just because a good idea becomes well-known, or widely accepted, doesn’t make it any less effective.

Andrew Ang, PhD
Andrew Ang, PhD
Head of Factors, Sustainable and Solutions for BlackRock Systematic
Andrew Ang, PhD, Managing Director, is Head of Factors, Sustainable and Solutions for BlackRock Systematic. He also serves as Senior Advisor to BlackRock Retirement ...
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