Buttonwood

Lots of investors bet on “factors”, such as size, value and momentum

But what if the crowd catches on?




THE FINAL of the European Football Championship in 1976 was settled by a penalty shoot-out. The winning kick, scored by Antonin Panenka of Czechoslovakia, was a thing of beauty. From Panenka’s long run-up and body shape, the West German goalkeeper, Sepp Maier, guessed that the kick would go hard to his left. He dived in anticipation. But Panenka did something novel. He calmly chipped the ball down the centre of the goal, which Maier had just vacated.

Armed with this story, we come scrambling back to the present to contemplate another game of fine margins: investment. Here too success often depends on the ability to outwit others. Indeed proponents of factor investing—buying baskets of stocks with characteristics that have been shown to beat the market averages—say it works by exploiting the enduring weaknesses of investors. If the dumb money keeps shooting for the corners, you profit by going down the middle. Just hold your nerve. 
This requires a faith that the future will be like the past. And where there is faith, there is always doubt. The world of investing evolves, just as football has. As more players adopted the Panenka, goalkeepers cottoned on. A new category emerged: the failed Panenka. A consideration of this begs a scary thought for factor investors: what if returns will be hurt by the ubiquity of the strategy itself?

The roots of factor investing go back at least as far as a canonical paper in 1992 by Eugene Fama, a Nobel-prizewinning economist, and Kenneth French. They found that listed companies that were relatively small, or whose stock price was low compared with the value of assets, had higher-than-average returns. They proposed that size and value were factors that justified a reward over and above that for bearing market risk, known as beta. Subsequent research identified other winning factors for companies with strong dividends (the yield factor) or high profitability (quality); or with share prices that have risen a lot (momentum) or that fluctuate only a little (low-volatility).


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. But it is harder to dream up a compelling risk story about, say, momentum or low volatility.

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. The rapid growth of index funds, in which investors settle for an average return by holding all the market’s leading stocks, suggests as much.

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 by AQR Capital 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. If factor premiums are also slimmer in future, trading costs will eat up a larger share of the extra returns.

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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