For Style Factors, One Size Does Not Fit All: A Summary
Many of us are familiar with the concept of factor investing, whether because of long-time knowledge about quantitative portfolio management, more-recent proliferation of “Smart Beta” products, or something else. We know that historical factor performance can be used as a guide to whether the factor could be used as a source of generating excess portfolio returns or thought of as an uncompensated source of portfolio volatility.
In a recent article in The Journal of Investing (Winter 2017 Volume 26 Number 4), we dug into returns from several of Axioma’s models to analyze them through time and across geographies. The purpose of the article was not to rehash why we use factor risk models or to highlight the benefits of some factors as return generators. Rather, we made three simple but important observations.
- Returns for factors (whether compensated or uncompensated) have varied widely through time
- Returns for a given factor at a given time can differ by quite a bit across geographic regions
- Use of any of the factors, especially for generating alpha, should align with the manager’s goals and patience of the underlying asset owner
We found that for some factors, local models fare better. For other factors, regional or global models may produce better (or at least similar) returns. We also noted what may be obvious to many investors, especially those with long experience, but can be forgotten at times of unusually good or unusually bad factor performance: don’t expect the good times to last indefinitely (for the former), and don’t panic during the latter.
The article narrowed down the wide range of fundamental models on offer by Axioma to five: US, Europe, Japan, Emerging Markets and Worldwide, using the medium-horizon variant where returns may have differed from short-horizon. We looked at relatively long periods (1999-2016 and 2010-2016) as well as quarterly and rolling three-year performance (for some of the factors). We showed how risk-only factors (with long-term returns close to zero) could occasionally have outsized returns for a quarter; limiting exposures to them may not make much difference most of the time, but can prevent big drawdowns when they go off the rails. We also tried to demonstrate how the need for consistent returns versus the desire to benefit from a factor with great long-term performance even with the occasional big drawdown (think Momentum in 2009) should drive the choice of alpha-generating factors. We also demonstrate regional differences in factor returns (e.g. Growth fares well in Japan but not in the US).
This is largely data we discuss in our quarterly Insight reports or our Weekly Equity Highlights, but takes a longer-term view of the pros and cons of different factors.
For access to the full article, click here.