Crowding, implementation costs, and careless trading—none considered, of course, in simulated paper portfolios—also trim realized returns.
Investors can mitigate the risk of factors underperforming their expectations by asking a few simple questions: Does this factor make sense? How crowded is this factor? What are the likely trading costs to implement this factor?
Researchers rarely apply these tests to newly discovered factors. Investors, therefore, must do it for themselves.
Naïve Risk Management Assumptions
Factors are prone to big drawdowns. Their return distributions are far from normal, being asymmetric to the downside with a fat tail—the probability of a negative return.
Unfortunately, too many investors rely on very simple risk management tools that ignore tail behavior. Additionally, too many investors mistakenly believe a multi-factor portfolio can eliminate extreme tail behavior through diversification.
Our research in “Alice’s Adventures in Factorland: Three Blunders That Plague Factor Investing” shows that actual factor drawdowns over the last 15 years would never have been expected if the factor returns were normally distributed with the same volatility.
We looked at the 14 most popular factors, dividing them into two groups. The first group is the 6 most popular academic factors in multi-factor models: value, size, operating profitability, investment, momentum, and low beta.
The second group includes another 8 popular factors: idiosyncratic volatility, short-term reversals, illiquidity, accruals, cash flow to price, earnings to price, long-term reversals, and net share issues. For details on how we build the long–short factor portfolios, please refer to the article.
An investor who assumes factor returns are normally distributed could never have foreseen the outcomes we observed in our analysis.
For example, the worst month for 11 of the 14 factors should have occurred less than once in the past 2,000 years. The worst month for 9 of the factors should have occurred less than once during the time modern humans have roamed the earth, and the worst month for 3 of the factors should have occurred less than once since the universe was created! So much for a normal distribution!
Not having a clear understanding of the potential for such extreme outcomes can be a very dangerous oversight for investors.
Diversification Can Vanish in Certain Markets
In periods of market stress, factors can move in unison. Thus, building a multi-factor portfolio to diversify risk does not always succeed as planned. Large drawdowns of individual factors often happen at the same time.
We compared the actual returns and the normally distributed returns of a portfolio holding the 6 most popular factors from July 2003 to July 2018. Actual performance was far worse than the performance a normal distribution would indicate.