In investing, as in a penalty shoot-out, what worked in the past cannot always be relied on to work in future
Investors took notice. Trillions of dollars are now invested in factor-based or “smart-beta” strategies. A new paper by James White and Victor Haghani of Elm Partners, a fund-management firm, sets out the reasons to be sceptical about their continued success. A first problem is the muddle over why factor premiums exist at all. One view says it is all about risk. Small or lowly valued firms are riskier because they might go bankrupt in a really deep downturn. You may buy that.
The alternative view is that factors exist because of the shortcomings of others. So momentum works because investors in general tend to react too slowly to good news about a company’s prospects. Other factor premiums are put down to industry frictions. If, say, pension funds have demanding targets, but are not allowed to use leverage to boost returns, a second-best strategy is to tilt the portfolio towards high-volatility stocks. Low-volatility stocks are thus unduly cheap.
The big question is whether we should expect these quirks to endure. Once a way to make above-market returns is identified, it ought to be harder to exploit. “Large pools of opportunistic capital tend to move the market toward greater efficiency,” say Messrs White and Haghani. For all their flaws and behavioural quirks, people might be capable of learning from their costliest mistakes.
Part of the appeal of index investing is that it is cheap. Factor investing, by contrast, involves a lot of churn—and thus expense. A detailed study byCapital Management, one of the big beasts of factor investing, finds that trading costs were around 40% of gross factor returns. The costs are mostly down to the weight of money moving stock prices unfavourably. This figure is high enough to warrant concern, say the Elm duo. It may go higher as more money piles in.
What worked in the past cannot always be relied on to work in future. Penalty shoot-outs used to be seen as lotteries; they are now exercises in data-mining. Every goalkeeper and kicker knows what his opponent has done in the past. The best penalty-takers still hope to induce the goalkeeper to move first. But goalies are not as easily fooled. They can hold their nerve, too.
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