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Problems with smart beta – part 5: It’s impossible to know when a factor stops working

This is the fifth post in a series discussing some of the problems associated with investing in “smart beta” strategies. For the previous post on how factors can decay after they become widely known, click here.

We saw in a previous post that factors in the US have been providing pretty torrid returns since 2003. Some factors, such as P/B and size, have been increasingly thought of as being “dead”, and may no longer expected to produce excess returns over and above what would be predicted by CAPM. However, by their very nature factors can go through periods of long underperformance – part of the very reason for their existence is that they’re risky. But how are investors supposed to know when a factor is just going through a bout of poor performance, or whether it’s stopped working completely?

The difficulty for factor investors is that there are a few major hurdles for knowing when a factor breaks down:

  1. Given how much data it’s taken for a tiny number of factors to be accepted as robust, we’d need an equal amount of data to prove they’d broken down. You could spend your entire investing career investing into a previously-sound-but-now-broken factor, and academics would likely still be debating its efficacy when you’re well into retirement. Researchers at Newfound Research tried putting numbers to test this theory, and found that it would take a median of 67 years to declare P/B officially dead.
  2. A broken factor would sometimes perform as if it still worked. Thanks to the noisiness of markets and humans’ ability to see patterns in randomness, a broken factor would occasionally perform as if it was still working. It would therefore be very difficult to tell when a broken factor’s outperformance was just noise, or whether the factor still worked.
  3. Financial institutions have invested huge amounts of money into rolling out factor-based strategies. If there were compelling evidence that a factor had broken down which the company had significant amounts of client assets in, it’s unlikely that they’d publicise it. Investors would be slow to discover the breakdown in the factor because financial institutions would have a vested interest in them not knowing.

Conclusion

A certain amount of faith needs to be adopted by factor investors, as they could realistically go through an entire investing career investing in a “dead” factor without realising. Factor investors need to make peace with this fact before investing, and maintain a certain amount of flexibility within their investment process to allow for portfolio changes resulting from new academic research.

The next post in the series focuses on how too much factor dilution in a portfolio can end up approximating market returns. 

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