Factor Investing
An Evidence-Based Approach
by Joop Huij
Executive Director, Head of Factor Investing Research, Robeco
Associate Professor of Finance, Erasmus University Rotterdam
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Evidence-Based Practice
> In complex environments learning is
difficult because lag between action
and response, and response signal
may be noisy.
> Medicine is perfect example of
complex but also highly relevant
field.
> To cope with complexity, evidencebased medicine (EBM) has been
embraced.
> EBM incorporates quantitative
methodology in the “art” of clinical
practice to objectively gauge the
effectiveness of treatments.
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Norges Study & Factor Investing
> Ang, Goetzmann & Schaefer (2009) study for
Norwegian Reserve Fund GPFG
> Active management of GPFG has added value
> This added value can be attributed to implicit exposures
to systematic factor premiums (betas), which arise from
bottom-up manager selection
> Recommendation: top-down approach to harvest factor
premiums intentionally and efficiently
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Factor Investing Framework
1. Traditional strategic asset
allocation
Government
bonds
2. Traditional break-down in
regions Equities
Japan
Equities
Europe
Government
bonds
3. Search for skilled managers
(alpha) Equities
Japan
Equities
Europe
Government
bonds
Equities
Equities U.S.
Equities U.S.
Credits
Legend
Risk-adjusted
expected return
low
Credits
Credits
Equities Low
Volatility
Eq. Lo.Vol.
Eq. Hi.Vol.
Equities
High
Momentum
Government
bonds
Eq. Lo.Val.
Eq. Hi.Val.
Equities
Equities
Credits
5. Strategically allocate to factor
premiums
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Government
bonds
Eq. Hi.Mom.
Equities
High Value
high
Eq. Lo.Mom.
Credits
4. Factor premiums drive alpha
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Numerous studies show that
certain groups of stocks have
historically earned excess returns
> Value vs. growth stocks
> Past winners vs. losers
(momentum)
> Low volatility vs. high volatility
Historical excessreturn
Exhibit A: Literature on Asset Pricing
10%
9%
8%
7%
6%
5%
4%
3%
2%
1%
0%
10%
Past winners
Value
Low vol
Market
Growth
High vol
Past losers
15%
20%
25%
Historical volatility
Implication: passive investing is
inefficient
> The capitalization-weighted market
portfolio simply invests in all
stocks, i.e., attractive as well as
unattractive ones
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30%
Exhibit B: Norges study
Ang, Goetzmann & Schaefer
(2009) study for Norwegian
reserve fund
> Historically, active management of
the fund added value
> Most of this added value can be
explained by implicit exposures to
systematic factors (betas)
> These factor exposures arise from
bottom-up manager selection
> Their recommendation is to
adopt FACTOR INVESTING
instead: allocate to proven
factors in a top-down, explicit
manner
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Exhibit C: Factor Investing pioneers
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Rebuttal A: Trading costs
Academic factors are based on hypothetical stock portfolios
>
>
>
>
Close prices are used
Dividends are assumed to be fully reinvested
Trading costs are typically ignored
Several studies argue that premiums are not robust to trading costs
ACG study shows that
the short-term reversal
premium
> is concentrated in
illiquid small cap
stocks
> is negative after
trading costs
Source: Avramov, Chordia and Goyal, Journal of Finance, 2006
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Rebuttal B: Adaptive Market Hypothesis
Adaptive Market Hypothesis
> Premiums might be priced/arbitraged away after public dissemination of
anomalies
> Several studies argue that premiums of some of the factors have become
smaller over time
Source: STR series from Kenneth French data library
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Do Factor Investing Funds Really Earn
Alpha?
However, while numerous studies report factor premiums, there is
currently no empirical evidence that investors that engage in Factor
Investing earn alpha.
Study by Huij and van Gelderen (2013) tries to fill this void:
>
>
>
>
Sample of 6,800+ U.S. equity mutual funds back to 1990
Data from Morningstar and Prof. French
Return-based Style Analysis
Focus on low-risk, small cap, and value styles (insufficient #momentum
funds)
> Outperformance measured relative to U.S. market
Main objective: investigate if Factor Investing funds show
better success ratio than the control group
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LowVol funds: Success Ratio is 50% (20% for
Control Group)
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Small Cap Funds: Success Ratio of Nearly
70%
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Value Funds: Success Ratio of More Than
60%
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Concluding Comments
> Since the 1990s a substantial number of investment funds is
engaging in factor investing
– Study for GPF and Robeco research recommend intentional and
efficient allocation to factor premiums.
> Factor Investing funds do significantly better than their peers:
– 0.6-0.7 standard deviations above average fund
– Net alpha of 56 to 119 basis points
– Success ratio of conventional active funds is only 20%; success
ratio of Factor Investing funds is 60-70%
> Continue discussion on why some Factor Investing funds are more
successful than others…
– Understanding source of factor premiums (e.g., risk-based or not)
– Monitoring of risks and avoiding unrewarded risks
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Source of Presented Results
The figures shown in this presentation are from “Academic knowledge
dissemination in the mutual fund industry: can mutual funds successfully
adopt factor investing strategies?” written by Eduard van Gelderen and
Joop Huij
The article can be downloaded from: http://ssrn.com/abstract=2295865
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Important Information
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