Factor investing is simple but not easy

Factor investing is exceptionally well-researched globally, and the evidence of its outperformance over the broader benchmarks goes back over 100 years. But does the overwhelmingly favourable evidence mean that investors should bet their houses on factor-based strategies? History suggests that factor investing can have extended periods of underperformance. John Maynard Keynes’ famous remark about markets remaining irrational for longer than investors’ ability to remain solvent is equally true for factor investing.

How painful can Factor investing get?

Factor investing indeed has its rough patches. Take the case of momentum, which is the most sought-after factor of recent times due to its outsized recent as well as high historical long-term returns. But the journey to those high returns has not been easy. Momentum crashes have typically occurred during times of market reversal, characterized by significant underperformance by stocks with the strongest momentum, even as stocks with negative momentum outperform. Some of the steep drawdown periods for the momentum factor in the US markets include the ~65% fall (markets: ~50%) during the recession midst of the Great Depression and the current ~44% fall (markets: ~21%) as of Aug 2022 owing to several macro risks. Although short history, the story is similar in Indian markets, with momentum falling ~36% (markets: 30%) during the unveiling of corruption scandals and the current ~28% fall (markets: ~18%) as of Aug 2022.

While momentum underperformance tends to be deeper, value-factor underperformance tends to last longer. There have been at least four ‘ten-year’ periods where the value factor underperformed the US benchmark. In India, the value factor is yet to outperform the market since its inception in 2005. Even star investors like Warren Buffet were second-guessing their value investing process during the tech bubble of the late 1990s when they massively underperformed growth stocks, reflecting how difficult it can get to stay the course and remain invested in the value factor.

Exhibit 1 & 2: Top: Drawdown; Bottom: Relative performance

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Can we reduce the pain in Factor Investing?

It’s clear that factor investing can give us headaches from time to time. So, can we take exposure to each factor instead of selecting/timing a particular factor? This is analogous to asset allocation but applied to factors. Such an approach is commonly known as Multi-factor investing. The idea is to cut down the downside risk without giving up much upside potential.

Exhibit 3: Historical Performance

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The above chart indicates that a simple equal weight combination of factors does not give up on returns – it is the second best strategy overall, after momentum. However, it significantly reduces portfolio volatility. The Sharpe ratio of a multi-factor strategy is ~15% higher than other single factors barring low volatility.

In addition, combining factors drastically improved the consistency of outperformance, even at moderate holding periods. The historical odds of multi-factor strategy underperforming the market is the least during 1,3,5,7 year periods compared to other factors. It goes to 0% for a holding period of greater than 15 years.

While there are many sophisticated ways to combine factors, data indicates that even a linear combination of factors is a lower-risk alternative to unlocking the benefits of factor investing.

Mr. Sankaranarayanan Krishnan, Quant Fund Manager (PMS & AIF schemes, Passive Funds), MOAMC