Now that we’ve looked at the major factors and the evidence behind them, the obvious question becomes why do these factors exist in the first place? And are they likely to continue?
Risk vs behaviour
Academics are divided over the exact reasons for factors’ outperformance, but most agree that there’s at least some combination of 1) being rewarded for taking on more risk, and 2) exploiting pricing inefficiencies caused by the behavioural biases of other investors.
Those who argue for risk being the primary driver of factor returns suggest that market beta isn’t the only form of non-diversifiable risk in markets, and factors offer additional risk that investors can take to provide positive expected returns. This seems like a sensible argument for those investing in the size factor (small cap stocks are riskier than large cap stocks), and the value factor (stocks with low prices compared to their fundamentals may be cheap for a reason, and so are likely riskier).
Those who argue for behavioural reasons suggest that stocks can be mis-priced because humans are irrational and bad at processing information, so stocks don’t fully incorporate all available information into stock prices. For instance, investors may over-extrapolate recent good news and pay too much for a stock, or over-extrapolate bad news and oversell.
If a factor is completely risk-based, then that’s great for investors because it means the premium can’t be competed away and will always exist – risky stocks will always be risky. However, it also (rather obviously) means that the stocks will come with higher risk. The pain of poor performance will come when it’s the most unbearable.
If a factor exists purely because of investor behaviour, then that’s also great for investors because it means you’re getting extra returns for no extra risk – the holy grail of investing. But there are a lot of smart people out there with huge amounts of capital to allocate, whose day job it is to try and exploit these inefficiencies. If we know about this inefficiency, then you can bet that they do too. It’s therefore very possible that the premium will reduce (or even disappear) because more and more investors are trying to capture the same premium, or the investors making these behavioural mistakes wise up and stop making them – or both.
So which is it? Risk or behaviour?
The short answer: nobody knows for sure. But it’s probably a combination of both risk and behaviour, with the relative weight of each varying over time, and dependent on the factor.
Let’s take the value factor as an example.
Value is likely partly risk-based. Value stocks are those that have had their prices hammered down relative to the value of the underlying business, which usually means investors don’t like them because they’re worried about the future cashflows. This makes them riskier investments. However, as AQR point out “if value works because of risk, there should be a market for people who want the opposite. That is, real risk has to hurt. People should want insurance against things like that. Some should desire to give up return to lower their exposure to this risk. However, we know of nobody offering the systematic opposite product (long expensive, short cheap). Although this is far from a proof, we find the complete lack of such products a bit vexing for the pure rational risk-based story”.
But value could also be partly behavioural. People tend to over-estimate growth stocks’ future growth rates, which leads to those stocks becoming expensive and value stocks becoming cheap. This sort of extrapolation led to the tech bubble in 2000, where exciting growth-y technology stocks were bid up to extreme valuations. It’s a behavioural argument for why the value premium exists – a reward for avoiding the periodic irrational hype around growth stocks. To capture the value premium, you need to endure the FOMO.
The same can be said of the momentum factor. The behavioural side of momentum is that investors tend over react to widely-publicised company news, and are also slow to incorporate small bits of good news. The result is that stocks that are going up tend to keep going up, and that stocks are going down tend to keep going down – but the trend reverses once the price moves too far away from the company’s fundamentals (academics tend to favour 12-month momentum). The risk side of momentum is that investors are compensated for the risk of occasional large crashes in stocks with high momentum.
In all likelihood, factors probably exist because of a combination of both additional risk and human behaviour. Factors are at least partly risk-based as they’ve endured over such a long time, over so many different asset classes, and so many different geographies. If they were purely behavioural, they would likely no longer exist. However, humans will never be perfectly rational, and there will always be behavioural inefficiencies for investors to exploit. Even with the rise of quantitative investing, human behaviour plays its part – not just in the initial design of investment models, but in their subsequent modification, and the possibility of human override. Jim O’Shaughnessy, the former Chairman and CEO of O’Shaughnessy Asset Management and author of ‘What Works on Wall Street’ noted that over 60% of quants overrode their models during the 2008 financial crisis. Even if all trading was purely quantitative, human behaviour would still play its part in setting prices.
It’s also likely that the combination varies over time – at some points the reason for a factor’s performance is mainly behavioural, and at other points its more risk-based. The tech bubble is a good example of where the value factor’s behavioural argument played a much larger part than its risk argument.
Conclusion
As we saw in the post on risk, the bottom line is that risk cannot be destroyed, only transformed. By investing in factors, investors stand a chance of outperforming a market-cap weighted index. But this chance of outperformance comes with additional risks, which are twofold: 1) the reason a factor exists at all is at least partly because it’s riskier than a market-cap weighted index, and 2) investors are taking the risk that the behavioural element of the factor is competed away or simply stops working due to investors wising up and overcoming their behavioural mistakes.
Click here for the next article in the series, which looks at one of the major problems of factor investing, the cyclicality of individual factors, and explores how investors can combine multiple factors to create a multi-factor portfolio.
Alongside the cyclicality of factors, factor investing has several other problems which investors need to be aware of. I’ve written about a number of them here.