Factor Investing: Sorting by a Number
Factor investing builds a portfolio by sorting shares on a measurable characteristic, such as cheapness, size, recent strength, profitability or low volatility, rather than by company-by-company judgment. Each characteristic is a pattern found in past data, and every one has long stretches where it does not work.
How it works
Factor investing is sorting shares by a measurable characteristic. A portfolio is built by ranking companies on one number thought to be associated with higher returns, rather than by company-by-company judgment or by market value alone.
Value, size, momentum, quality and low volatility. Those are the characteristics most often sorted on: cheapness against fundamentals, small company size, recent relative price strength, profitability and balance-sheet quality, and low variability of price.
Each is a pattern found in historical data. Two explanations compete. Either the characteristic marks a risk investors are compensated for bearing, or it marks a behavioral error that keeps repeating, and the numbers alone cannot settle which.
And a published pattern gets traded against. A characteristic that predicted returns while nobody was looking at it is a different object once a great deal of money is sorted by it. Whether the premium survives that crowd is genuinely open.
Every factor has decades where it does not work. Each of them has produced stretches of underperformance long enough that almost nobody holds through one. That is the practical problem with the whole approach, not a footnote to it.
From the pattern to the portfolio
Hundreds have been published and few survive testing. The process that produced them, searching historical data for characteristics that predicted returns, is exactly the process that produces false ones. Overfitting is the name for that failure.
And the definition changes the result completely. Cheapness can be measured against earnings, book value, cash flow or sales, and each choice produces different holdings. Two funds tracking the same named factor can own substantially different portfolios.
The fund fee is subtracted from the factor. Exposure is normally bought through a fund, so the annual charge, the turnover from rebalancing and the spreads paid on it all come out of whatever premium exists before you see any of it.
Some factors only work in names too thin to buy. An effect concentrated in small cap shares can fade when a large fund tries to trade it, because the volume is not there at the prices the backtesting assumed.
The evidence is measured in decades. Quantitative analysis of a factor needs a very long sample before it says anything, which means the evidence you are leaning on and the horizon you must hold for are the same length.
In practice
And the unwind can arrive in a single week. A crowded factor can reverse quickly, with an opening gap doing most of the damage before anybody rebalances. Slow to build, quick to come apart.
There is no stop on a factor exposure. A stop loss makes no sense here, because the whole proposition is holding through the bad stretch. Even the broad S&P 500 took 1,897 trading days, from January 1973 to July 1980, to close above an old record, and a factor tilt can trail the index for stretches as long.
Every rebalance pays trading costs again. Each sale and purchase inside the fund crosses a spread and may carry a commission, and a factor fund pays those at every rebalance, not once.
Compare the fee against a plain index fund first, not last. Index funds and broad exchange-traded fund holdings set the benchmark charge, so ordinary ETF investing is the right yardstick. The factor version costs more, and that difference is the price of the whole idea.
And check what you already own. A factor fund held beside a broad index fund usually has high correlation with it and carries ordinary market beta as well, so the tilt is a smaller part of the position than it looks.
Writing the exit before the entry
The decision that matters is made before you buy. How long will you hold this exposure, and what would actually count as evidence that it has stopped working? Both questions are answerable in advance and almost unanswerable during the lag.
During a lag every answer is contaminated. The underperformance itself supplies the argument for selling, and that argument always sounds like analysis rather than discomfort. Which is why the holding period has to be written down while you are calm.
So write two sentences. The first is the minimum period you will hold regardless of results. The second is the specific condition that would end it: a change in how the fund defines the factor, a rise in its charge, a merger into something else, or the exposure no longer being the one you bought.
Then leave both alone. A rule revised in the middle of a lag is not a rule. If you cannot write either sentence honestly today, that is your answer on whether to buy the fund at all.
What factor investing is not
- Not company-by-company judgment. The sort decides the holdings; no view is taken on any single firm.
- Not a market-neutral position. Most factor funds are long only and carry ordinary market risk on top.
- Not a timing signal. The characteristic ranks shares against each other, never the market against itself.
- Not a cheaper index fund. A factor fund charges more, and that extra charge is the certain part.
How this connects
The funds are usually sold as smart beta, a rules-based tilt that sits between a plain index fund and active management.
Passive investing purists object that the tilt is an active bet, and the tracking error against the broad market is the measure of how large that bet is.
The risk-based explanation treats each factor as a risk premium, much like the extra return shares earn over cash for bearing market swings.
The value factor sorts on cheapness measures such as book value against price, which is why the value stock and growth stock labels used by index providers come from the same sort.
Momentum trading is the short-horizon cousin of the momentum factor, and mean reversion over longer periods is one reason value and momentum pull against each other.
The low volatility anomaly is the most counterintuitive of them, since theory says calmer shares should earn less, not more.
Performance is often judged by the Sharpe ratio, because some factors earn their edge through lower volatility rather than higher returns.
Asset allocation comes first. A factor tilt is a small adjustment inside the equity slice, not a substitute for diversification across holdings.
And systematic risk remains. A factor fund still falls when the whole market falls.
When it fails
The exposure can be perfectly sound and still impossible to hold. These are the cases that do the damage:
- A flat decade leaves only the charge. In a long sideways trading range the premium may not appear at all, while the fee is taken every year regardless.
- The lag outlasts the reason you bought. Ten years of underperformance sits inside the range these characteristics have produced before, so “is it broken?” cannot be answered while it is happening.
- The drawdown is not the one you sized for. A factor fund can fall further than the index it was meant to improve on, at the moment you most want it to hold up.
- Crowding is invisible until it unwinds. There is no way to see how many other people are sorted the same way until they all try to leave together.
- The fund quietly changes its definition. A rules revision or a benchmark switch can leave you holding a different factor from the one you looked into.
- Two factors at once can cancel out. Value investing and a momentum stock screen often want opposite shares, and a blend of the two can end up holding neither with conviction.
The original data
The question: The factor has lagged ten years. Broken?
The scan is in this site’s search study. Across the 24,971 trading and investing videos in this site’s search study, 3 titles mention factor investing, from 3 channels, at a median of 50,285 views and a maximum of 62,521. Two titles mention overfitting, from 2 channels, median 299 views.
Factor research is the single largest source of data-mined results in finance. The concept that decides whether a published factor was ever real is discussed in two videos out of that whole corpus. “Monte carlo”, “expectancy” and “risk of ruin” appear zero times each.
The individual factors are covered far better than the idea behind them. “Value investing” appears in 78 titles from 52 channels at a median of 13,135 views, “small cap” in 12 titles from 11 channels at 3,868, and “momentum stock” in 7 titles from 6 channels at 908.
The fee arithmetic needs no market data at all. Compounding an annual charge alone over thirty years, with no return assumption at all, 5 basis points removes 1.5% of the pot and 20 removes 5.8%. A basis point is one hundredth of a percentage point.
At 75 basis points it is 20.2%, and at 150 it is 36.5%. The fee is certain and the premium is not, which is the honest comparison to make. Before buying any factor fund, write down your holding period and your abandonment condition, then put its charge next to a plain index fund’s as the first step, not the last.
Related
Value investing is the oldest of these characteristics and the one that tests patience hardest, which makes it the fairest test of whether you can hold a factor at all. A momentum stock screen sorts on the opposite signal, which is why a blend of the two so often ends up with conviction nowhere. Overfitting is the failure that decides whether a published factor was ever there, and it is the first question to ask about a new one.
A factor exposure only pays if you hold it through the lagging years, and that is exactly where it is hardest to stay. The reasoning starts to feel dated, something else is visibly doing better, and a tidy argument for why the factor is finished is easy to produce. Decide in advance how long you will hold, because the argument is rarely the real reason for selling; the discomfort is.
— Michael Whitman
This page is educational, not financial advice. Test every idea on your own charts before risking money.