How Painful Can Factor Investing Get?

Current vs Past Agonies

August 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • A classic long-short, multi-factor portfolio has lost close to 20% since 2018
  • The drawdown is within expectations, but the recovery period is abnormally long
  • However, it’s difficult to argue for structural changes that make factor investing unattractive

SEEKING DIVERSIFICATION THROUGH MULTI-FACTOR PRODUCTS

Investors have flooded into multi-factor strategies over the last several years.

The latest FTSE Russell smart beta study found that 71% of the investors surveyed used such products, up from 49% in 2018. Single factor products were in far less demand. The two most popular – Low Volatility and Value – were used by only 35% and 28% of respondents, respectively.

This is understandable. Since individual factors are as cyclical as equity markets, multi-factor strategies offer diversification benefits and help moderate risk. For example, the Value factor generated negative excess returns in nine out of the last 10 years, constituting a lost decade for Value investors.

Still, while diversifying across factors yields more consistent performance, multi-factor strategies are not immune to significant drawdowns. The last 18 months have not been kind to factor investors, and multi-factor products – with an almost 20% decline – have provided little relief.

So just how painful can factor investing get? Placing the current drawdown in long-short, multi-factor products into historical context offers some insight (try Finominal’s Return Predictor for expected returns).

THE CURRENT STATE OF FACTOR INVESTING

With outperformance so elusive in recent years, investors have poured almost $1 trillion into smart beta products – long-only strategies with factor tilts – in hopes of generating alpha. While smart beta differs from the long-short portfolios