Value, momentum, size, quality, volatility, etc as factors in investing are quite popular. They’ve produced significant outsized returns relative to benchmarks. Now, we even have Smart Beta funds and ETFs popping up all over to make taking advantage of factors super easy. That brings up the critical question every investor interested in taking advantage of factors in their portfolio should ask – will the outperformance of factor investing continue in the future? Here I’ll take a look at a recent post from Alpha Architect that addresses this question. In short, investors should expect past outperformance to decrease in the future.
Basically, there are two reasons why outperformance could go away; data mining (the factor is not real and just an artifact of the data) and arbitrage (basically investors becoming aware of the anomaly, investing in it in a big way, and thus it disappears). The Alpha Architect post references a study that looked at out of sample performance of factors. Below are the results.
Basically, out of sample returns are lower than what the historical results had shown. The returns were about 40-70% of what they were in the past. Sobering. But as I’ve discussed on the blog in the past some factors are better than others. In another post , a bunch of factors are analyzed and the only two sustainable ones are value and momentum. This is the reason all the strategies I use are primarily focused around these two factors. But one of the reasons that value and momentum work is that they come with periods of awful performance, absolute and relative, and drawdowns. All of which making them very difficult to stick with over the long term. And if history is a guide investors should expect their relative outperformance to decrease going forward as more investors become aware of them.
In a way, these factor strategies are even harder to stick with than just simple buying and holding of traditional index products. When you’re indexing at least you’re doing no worse than the index! There is no FOMO (Fear of Missing Out). If you’re not willing or able to tolerate underperformance, potentially for long periods of time, then you won’t be successful with factors. But I think the are a several things investors can do to increase their chances of success going forward.
- Reduce expectations: I always reduce potential outperformance by at least half when I look at implementing a strategy
- Diversify: use multiple strategies – buy and hold indexing, TAA, smart beta, individual stocks. There’s a very strong chance at least one of the strategies will be outperforming, thus increasing your chances of sticking with your program. It doesn’t and shouldn’t be all or nothing.
- Stick with what works – value and momentum strategies have stood the test of time…at least so far. Dampen portfolio volatility with bonds.
- Reduce noise – there is a lot of noise in markets today. Investors need to work hard to tune it out. Try and go 1 month without looking at the market. Most investors I know can’t go a week.
- Have an investing process – investing your money shouldn’t be haphazard and random. As with many things in life having a system and process will help you achieve success. What are your goals? How does your portfolio match those goals? When do you rebalance? What strategies are you implementing and why? Do the same things at the same times on a regular schedule, etc…
In summary, factor outperformance could very possibly decrease in the future. But they are still likely to be very powerful wealth building strategies if investors can stick with them and not expect the future to be exactly like the past.