Smart beta specialist Research Affiliates has highlighted three problems with factor investing that, if not understood properly, could leave investors tumbling down the rabbit hole.
In a research note, entitled Alice's Adventures in Factorland: Three Blunders That Plague Factor Investing, the firm said factor returns have fallen "far short" of investor expectations in recent times despite the widespread uptake from the investment community.
The factor investing industry reached $1.9trn assets under management (AUM) at the end of 2017, up from $643bn in 2011, with BlackRock forecasting it could reach $3.4trn in 2022.
The three misconceptions the smart-beta specialist highlighted are "exaggerated" expectations on factor performance, larger than expected downside shocks and factor investing's diversification benefits.
"Factor investing has failed to live up to its many promises," Rob Arnott, founder and chairman of Research Affiliates and co-author of the report, commented. "It is a powerful tool, but understanding the risks involved is essential before adopting this investment framework."
Exaggerated expectations on factor performance can be due to a variety of reasons, the report noted. One issue is many factors, when backtested, can look good purely by luck or as a consequence of data mining.
Real-world returns can disappoint once the factor becomes crowded however, backtest results fail to reflect the market impact when a strategy sees inflows.
"As the factor becomes crowded, too many investors seek to make approximately the same trades and the mispricing disappears," Arnott explained. "The anticipated arbitrage leads to disappointing returns.
"There are no easy answers here. Our message is that investors need to be sceptical of claims of any new factor's performance."
Another dangerous misunderstanding, the report highlighted, is the belief factor strategies can eliminate extreme tail behaviour and avoid major downturns.
In particular, the two factors that can witness the biggest drawdowns are momentum and illiquidity. "Momentum is known to be prone to crashes, and the prices of illiquid companies tend to plummet when liquidity dries up.
"Investors often have a naive view of the tail behaviour of factor strategies," Arnott continued. "An investor who assumes that returns are normally distributed could have never foreseen that the factor's returns could be as extremely negative as they sometimes turn out to be."
The final issue investors need to understand with smart-beta investing is around correlations as many believe they can diversify away most of the factor risk by creating a portfolio of several factors. However, the report said in periods of market stress, most diversification benefits can vanish as the factors begin to move in the same direction.
Therefore, Arnott stressed it is vital for investors to understand how factors behave in different market environments such as economic expansion or recession, high or low inflation and market volatility.
"It is no secret that factor returns have recently fallen far short of investor expectations. Given that it has not lived up to [the hype], do we discard it, or do we rein in our expectations and pay close attention to implementation shortfall as we carefully embrace some use of factor investing? We favour the latter," Arnott concluded.