What Two Centuries Of Data Tell Us About Investing

As factor investing propagates, new analysis from Robeco Institutional Asset Management based on two centuries of data sheds light on its performance. Factor investing seeks an edge over broad market investing by identifying certain characteristics that may outperform. Today, according to FactSet, Smart Beta ETFs with assets over $900 billion use a factor investing approach.   

While certain investing styles or factors have always been popular, it wasn’t until ETF providers rigorously tested for factor persistency that it became more mainstream. However, one of the limitations of the current analysis is that it is mainly based on data from 1981 to 2011. While 30 years sounds robust, it doesn’t allow for reliable out-of-sample testing. How do we know any conclusions are not the result of luck or data mining and will persist?

Working with a global historical data company, Global Financial Data, Robeco amassed and crunched over 200 years of data covering global stocks, bonds, currencies and commodities to find the answer.

What Factor Research Tells Us

Robeco back tested six investing factors: (1) Momentum (outperforming securities tend to continue to beat laggards), (2) Value (high dividend/income yield), (3) Carry (high current yield), (4) Betting against beta (low beta outperforms high), (5) Trend (12 month excess return is predictor of future) and (6) Seasonality (buying at certain times of the year). It applied consistent testing methodologies, whereas existing research was based on a range of models.

Robeco’s research found low correlations between the six factors, implying they represent independent sources of risk and return. Of the 24 factors investigated (four assets and six factors), 19 of those were highly significant.

Trend, Carry and Seasonality showed dominant risk and return characteristics across all asset classes. Momentum and Value were significant for three asset classes, while Betting Against Beta was only relevant for equities.

The number crunching confirmed that factors were persistent. This is an affront to efficient market theory, which insists that investing factors shouldn’t beat holding the broad market index over an extended period.

For example, always picking trending assets or those with attractive carry shouldn’t give you an edge. And, if the characteristics are widely known, then the price should quickly adjust to eliminate the premium.

Regardless, two centuries of data tell us these factors have survived.         

Why Have Factors Persisted?

There are two potential explanations. Either the factor advantage is compensation for risk, or it is because of investor behavioral biases.

Robeco analyzed all economic and market cycles and found that factors were fairly independent of risk. That is, the factor advantage didn’t expand or contract with market shifts. So why don’t investors grab this free lunch and eventually bid away its advantage? The obvious culprit seems to be some behavioral biases. One such bias is herding.

Most managers are scored against a widely accepted benchmark. There’s a significant incentive to either hug the benchmark or not stray too far, so securities outside the benchmark get less attention.

More perversely, any large holdings within the benchmark, particularly those that are volatile, tend to be fully owned since any mismatch could skew the manager’s performance. That demand tends to eliminate risk premiums for large volatile stocks, while non-benchmark companies with healthier returns may get overlooked.      

Another bias is heuristics or rules of thumb such as “great companies are great buys”. Great companies have a tendency to be overpriced, which can deliver subpar performance. Meanwhile, as value investors know, many interesting opportunities are with companies that have hit a rough patch and may still be planning a turnaround.

Simply extrapolating the recent performance of value companies can be misleading, but many investors do just that and remain discouraged by what they see. Explaining the upside to investors may sound jaded, rather than pitching the next Facebook. So value investing is a tough sell and can seem out of touch with high flying peers.

Carry is another factor that is typically related to more mature opportunities that offer stable cash flows and higher income. These related companies are more utility-like and rarely ignite the same enthusiasm as the next potential unicorn that’s positioning to change the world as it burns through cash. 

Behavioral Finance Has Something To Teach Us

There are some polarizing views on whether factor investing or Smart Beta will persist. Rob Arnott, a heavyweight in quantitative finance, argues in “How Can Smart Beta Go Horribly Wrong?” that once the research gets published, many of the factors stop working. He also argues that much of Smart Beta performance is due to rising valuations potentially driven by herding that could end badly if prices correct. His counterpart, Cliff Asness, responded with lengthy rebuttals in “Smart Beta, Not New, Not Beta, Still Awesome”. 

Efficient market theory, the academic bedrock of investment markets, suggests that factor investing shouldn’t reliably beat the market when adjusted for risk. Yet, two centuries of empirical data show certain investment styles can outperform with no incremental risk.

Daniel Kahneman, one of the intellectual fathers of behavioral finance, has extensively researched investment decision making. One of his insights in his influential book “Think Fast and Slow” is that we give priority to bad news.

For our early ancestors, that quick impulse was essential in avoiding predators. And, while markets may sometimes feel like hungry lions, they are not. So rather than fleeing with the herd, there is value in slowing down to evaluate the different options. Investors may uncover some gems – and as two centuries of data tell us, there are certainly some still out there.

This material contains opinions of the author, but not necessarily those of Sun Life or its subsidiaries and/or affiliates.        

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I am an insurance asset management industry veteran with over 30 years’ experience at global financial firms. As CIO of Sun Life Financial, I lead a 240+ global investme...