Quant Funds Are Getting a Bad Rap
(Bloomberg Opinion) -- Poor results in the first half of 2018 have led to a backlash against so-called factor investing, which is a strategy that chooses securities based on certain attributes such as profitability or price volatility. But many commentators talk as if the results are worse than reality suggests. These are strategies with decades of strong evidence in favor of them, both in terms of academic studies and realized performance, in diverse market conditions. This year represents a normal downturn.
From the 1960s until around 1990, the dominant model in academic finance was a “single factor” model. The expected excess return on any security was equal to its beta multiplied by the expected excess return on the market portfolio. The expected return on the overall market was the single factor that determined expected returns for all assets. There were many alternative models in the literature, including models that allowed infinite numbers of factors, but many finance professors were satisfied positing a single factor. Contrary evidence was an “anomaly” that required further investigation, but that would one day be resolved.
Eugene Fama and Kenneth French published an exhaustive and authoritative demonstration in 1993 that expected returns depended on multiple factors. These factors, such as size (small stocks have higher risk-adjusted returns than large stocks) and value (cheap stocks have higher expected returns than expensive stocks), showed that investors could beat the market using simple investment rules.
“Style” or “smart beta” funds buy stocks with good factor exposures — small, cheap and so forth. These funds go up and down with the market, but should do somewhat better in the long run. Then there are “equity neutral” funds that go long the stocks with good factor exposures and short the stocks with bad factor exposures. These are designed for index fund investors to add to their portfolios. The point isn’t whether they beat the market, but whether an index fund plus an equity neutral fund beats the index fund alone.
The table below shows data from French’s website from the end of 1990 through the end of May 2018. An index portfolio returned 5.5 percentage points per year above one-month Treasury bills. Only momentum among the five factor portfolios had a higher return, yet all factors were valuable due to lower volatility than the market and negative correlations. The “Portfolio” column shows the result of putting 75 percent in the market and 25 percent in all five factor portfolios. Returns went up 4 percentage points (9.5 percent per year from 5.5 percent); volatility and drawdown dropped.
These are theoretical portfolios formed without fees or expenses, but they are built on simple rules. Fama and French define “value,” for example, as shares with a low price-to-book ratio. Mutual funds based on factors can use sophisticated definitions of value (for example, correcting data errors; adjusting accounting data with industry- and country-specific rules; and considering earnings, cash flow and other metrics).
The next table shows performance for 2018. It’s been a bad year for “Value” and “Conservative” (long companies with conservative investment policies, short companies with aggressive investment policies). “Momentum” has done well overall, but was negative in June. The sum of the factor portfolio returns is negative 3 percent. That’s bad, but the mistake is to compare this to the market return. These portfolios have negative correlation to the market, and they are not expected to beat the market. And despite the losses, the portfolio of 75 percent index and 25 percent factors did better than the market index fund.
These are theoretical results from the Fama-French factors, but they are roughly consistent with market experience. Equity market neutral funds only use factors, and have mostly lost money, primarily because they are long cheap, conservative companies and short expensive, aggressive ones. Style funds that combine market plus factors have generally underperformed the market (the Fama-French version beats the market by a little, but style funds have higher fees and expenses than index funds).
If you believe the long-term, broad-based and out-of-sample evidence for factor investing — and are willing to accept risks associated with leverage and high turnover, plus higher-than-index fees — nothing that has happened in 2018 should change your mind. If you never liked factors in the first place, well, low-cost, well-diversified, tax-efficient, unlevered index funds have always been sound choices; and there are plenty of other quant and non-quant approaches.
Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of "The Poker Face of Wall Street." He may have a stake in the areas he writes about.
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