The Case Against Factor Investing
Long Live Plain Beta?
May 2020. Reading Time: 10 Minutes. Author: Nicolas Rabener.
SUMMARY
- Factor investing is likely the best option for investors seeking to outperform the market
- However, the cyclicality of factors makes factor investing challenging when it underperforms
- Investors that do not understand this cyclicality are likely better served by plain, rather than smart beta
FREE AIN’T EASY
Free and easy are concepts that often go hand-in-hand. However, there are also many instances where free does not equate to easy. Technology and innovation have made investing free as investors can buy core equity ETFs that feature zero management fees and use mobile apps like Robinhood that charge no trading commissions.
However, making good investment decisions is still very hard. The DALBAR investor behavior study for 2018 highlights that the average retail investor in the US lost 9.42% in equity funds, compared to a decline of 4.38% in the S&P 500, which is explained by poor market timing decisions (or put in more precise terms, as the difference between dollar-weighed returns and buy and hold returns).
Retail investors are often called naive money in the financial media, however, the track record of professional fund managers is not particularly impressive either. The S&P SPIVA Scorecards show that almost all equity fund managers underperformed their benchmark over a 10-year horizon, which is long enough for a manager to prove his skill. Unfortunately for capital allocators, the lack of skill generating consistent alpha does not only apply to the highly competitive US stock market, but as well to international, market segments, sectors, and even emerging markets.
