The ‘factors’ investors should be wary of

Experience tells me that if you like having arguments with fund managers, or just generally annoying people, one really good way to do that is to initiate a conversation about passive investing.

Asset managers tend to either love it, and bristle in irritation if you fail to love it as much as they do, or hate it because they pick stocks for a living and index tracking funds are eating their lunch, degrading their expertise and even, some reckon, sedating markets.

But there is, of course, a third way in between bunging your money in a stocks index for a tiny fee on the one hand and paying an active manager quite handsomely in the hope it will pick all the right stocks on the other, and that is factor investing. Happily for those of an argumentative persuasion, this is studded with disagreement too.

The idea behind factor investing is to bundle together stocks by how they behave or by the types of companies they are attached to, not simply by country or industry. So instead of cobbling together stocks in, say, tech or energy or consumer goods, you assemble stocks with similar characteristics, like value — with low price-to-asset ratios — or those that are in a clear rising pattern, or those that relate to small companies rather than their larger cousins.

In theory, the time for this kind of investing, also often known as “smart beta”, is now. It is cheaper for the end users than the noble art of active management — an investment style that sceptics see as a pointless extravagance. But it should also do a better job, compared with just tracking national indices, of picking out winners and losers from a broad environment.

Already, over $2tn is parked in factor-based exchange-traded funds constructed by hundreds of providers in dozens of markets around the world, according to data from LSEG Lipper, making up about a fifth of assets under management in ETFs. 

It is important to ask, then, whether factors work. This has been a point of debate for decades, and it has often boiled down to the observation that what works well if you torture the data in a backtesting environment often dissolves on contact with the real world where it gets arbitraged away or kiboshed by ephemeral shifts in investor behaviour. 

The latest Investment Returns Yearbook from UBS (now in its 25th year and constructed on data spanning 124 years) attempts to answer the question by tracking the performance of various factors over several decades. Over the very long run, slicing up performance by decades running back as far as 1900, factor investing does demonstrate decent relative returns.

But the shorter-term picture is not pretty. The study shows that 2023 was particularly tough for factor investing in the US. Investing based on momentum (or chasing winners), small size, value, high income and low volatility — the five main factors — all bombed in comparison with the performance of bets pointing the opposite way. Momentum lagged by 1.6 per cent while, at the other end of the scale, low volatility trailed by some 32.4 per cent. But that’s not the case everywhere. In the UK, factors had a somewhat better ride, with momentum, for example, beating by 12.4 per cent, and value and size also generating a positive premium, while income and low volatility flopped.

This kind of inconsistency matters. The ranking of the main factors against each other flips around wildly from one year to the next and shows no consistency across different countries. The frequent tendency of various factors to underperform means that “at best, factor investing is a long-term strategy”, notes the report by Elroy Dimson, Paul Marsh and Mike Staunton. 

Crucially, it is hard to predict with any certainty which factor will do well in any period in future. If a factor performs badly in one year, or a series of years, you might think that sets the scene for a bounce back in the following year. Not so, the study says, looking in particular at value. Growth stocks have pulled ever further ahead of value in recent years, but the study’s authors say they “found no relationship” between previous episodes of widening gaps and subsequent recoveries. “As with all mechanical timing signals, it provides too many premature buy and sell calls,” they wrote. 

Indeed, value, as an investment factor, simply stinks. Taking data from 2008 to 2023 in the US and UK — value was the worst-performing major factor nearly a third of the time. Worse, value investing can leave investors who buy and hold the strategy under water for decades at a time because of its long periods of successive negative premiums, or underperformance relative to growth-focused investing. This factor has generated 37 successive years of negative premiums up to 2023. In the UK, the longest run of underperformance was the 34 years up to 2000. 

Factor investing, while “disappointing”, as the study rather drily notes, is unlikely to go away. It provides a useful way for investors to measure performance. But as the paper concludes, “whether [it] will generate premiums in the future is a harder call”. Those hunting for a magic trick to beat the market should look elsewhere.

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