Some Thoughts on the Struggles of Factor Investing in the Past Decade

By Jack Forehand, CFA (@practicalquant)
The long-term evidence to support factor investing is compelling. Academic work has shown that factors like value and momentum have produced an excess return relative to the market over time. Whether the explanation of that excess return is risk or behaviorbased, or a combination of both, is the subject of significant debate, but there is little doubt that there have been premiums associated with factors over the long-term.

But what occurred in the most recent decade was in many ways the opposite of what has happened over the long-term. Almost anything an investor did to get away from buying large growth companies over that period was a detraction from returns. Value was the worst offender, but quality, trend and even momentum all trailed a simple approach of buying big and expensive stocks. Low volatility was the one significant bright spot as it not only delivered on its promise of being less risky than the market, it also outperformed it. Quality also had a smaller positive premium, but the two most used factors in value and momentum both had negative premiums. The chart below, sourced from Portfolio Visualizer and the AQR factor data set, shows the risk and return statistics of the long/short implementations of value, momentum, quality and low volatility factors from 1/2009 to 12/2019.

FactorKeyAnnualized ReturnAnnualized Standard Deviation
Bet Against BetaAQR-BAB9.68%8.09%

source: Portfolio Visualizer, Factor Statistics

The struggles of factor investing, particularly value, over a long period of time has led many to question whether factor investing is permanently impaired, or whether this is just another of the regular periods of struggle that factor strategies have been prone to throughout history. I certainly can’t provide a definitive answer to that question, but as we look back at the decade we just completed and think about what went wrong, I do think there are several major lessons that can be learned.

Here are some of the biggest lessons that I think are important to keep in mind as we analyze the past decade and what it means for the future

1) If you want to know whether a factor is dead, you likely won’t find out in your lifetime.

As a quant investor, I like to focus on drawing conclusions that I can state with statistical significance. Nothing is ever certain, but having data to back up what you are doing and a high level of confidence in what that data says is very important. This can cause a problem when a strategy that has worked over the long-term has a significant period where it struggles. The reason is that the length of time it takes to statistically disprove a strategy that has worked over a long period of time can be longer than any investor would be willing or able to wait to figure it out.

Corey Hoffstein of Newfound research wrote an excellent piece, Factor Fimbulwinter, which I highly recommend you read, where he explained this better than I can. But to jump straight to the conclusion, here are the lengths of time he came up with that it would take to definitely say each factor is dead.

Unless there are some anti-aging drugs coming that I haven’t heard about, this means that none of us would be able to definitively that any of the major factors are dead within our investing lifetimes. As a result, during periods of struggle, factor investing will always include an element of faith that the long-term data will win out over the shorter-term concerns.

2) It is important to understand what long-term really means

This point goes hand in hand with my first one. When I first started my career, I thought five years was a long enough period to evaluate an investment strategy. As I gained more experience and learned more, I started to think ten years was more appropriate. I now think the right answer is more like twenty years.

If you look at the long-term history of the major factors, all of them have had significant periods where they struggled over five years. They all have also had ten-year periods where they didn’t work. And some have even had twenty-year periods of underperformance. What this means from a practical standpoint is that to generate the long-term excess returns from factors, you very well may have to endure a period longer than a decade at some point where what you are doing doesn’t work. Value investors know this all too well because they are going through a period like this now. If you judge factors based on five-year performance, or even ten-year performance, it may lead you to abandon a strategy at the wrong time and lose the benefit of following the strategy in the first place.

3) There are many flavors of factor investing. Make sure you choose the right one for you.

I like to look at factor strategies as a sliding scale. The scale starts with the market portfolio on one end and moves all the way to aggressive, focused factor portfolios on the other. Matching each investor with the proper point on this scale is essential to achieving success.

For most investors, the risk the market provides is more than enough without adding the additional risk of a portfolio that looks different than the market and can underperform it at times. Those investors should invest in an index fund. As you slide across the scale, you come to a group of strategies that use factors to reweight the market or slightly alter the market portfolio. These strategies are not likely to achieve the excess returns of focused factor approaches, but they are much easier to stick with and are great for investors who want some exposure to factors, but also don’t want the pain that can come with more aggressive approaches. As you make your way to the end of the sliding scale, you will find focused factor strategies. These strategies look very different than the market and are also likely to generate the largest excess returns over time. But the vast majority of investors will not be able to handle the ride to get there.

As you look at the different points on this scale, it is important to understand that no one point is necessarily better than another. The correct point on the scale is different for every person. The key is matching each investor with the right point.

The Future of Factors

As we look to the next decade, it is difficult to predict what will happen with factor investing. Some think that factors have become crowded and their premiums will be lower or disappear entirely in the future. Others think that what happened in the past decade is an anomaly and things will reverse to long-term trends. I tend to fall in the second camp, but either way, the outcome is far from certain. What is clear is that the key to achieving the premiums associated with factor investing is being able to endure the pain it will present along the way. Hopefully for those of us who use factors, the next decade will be filled with less pain and more premium.

Photo: Copyright: / Gajus

Jack Forehand is Co-Founder and President at Validea Capital. He is also a partner at and co-authored “The Guru Investor: How to Beat the Market Using History’s Best Investment Strategies”. Jack holds the Chartered Financial Analyst designation from the CFA Institute. Follow him on Twitter at @practicalquant.