We wrote about the underperformance of multi-factor portfolios at the beginning of 2019, and here we are two years later. And, while much has changed in the world with pandemics, presidents, and top Netflix shows (does anyone even remember Bird Box?), one thing that has stayed consistent is multi-factor investing approaches have delivered disappointing performance.
Even after a roaring comeback of a 0.5% return in 2019 (sense the sarcasm), multi-factor portfolios were down again in 2020, resulting in a negative three-year performance. While incredibly disappointing during a time frame where the S&P 500 Index was up nearly 50%, it is still better than strictly value-based approaches, which as you can see below, have been down by pretty significant amounts over the last four years.
Source: Factor Research
It is indeed a tough pill to swallow for investors in these strategies, and for a firm with funds employing multi-factor, quantitative-based approaches; believe me, we feel the pain too. While frustrating to live through, and the immediacy of recent performance makes the pain feel even more acute, it doesn’t mean that these types of approaches will never work again. As you can see in the chart above, factor-focused strategies did very well the eight years prior. Unfortunately, a common characteristic of factor returns is that they have periods of drought, so this is not unusual.
Given many of these factors have low-to-negative correlation with one another, it’s unusual that they are ‘all not working’ at the same time; but the fact that they don’t always work over every single environment is not new. I wish I knew all the reasons for the struggles (I think the market being driven by a small number of mega-cap growth names with varying levels of volatility is one thing) so I could make some brilliant predictions about when it will change, but alas, I will not. I can address, however, the importance of understanding the intricacies of approaches in this space–because while it is a narrow subset of strategies, there is a wide range of performance due to the process employed.
We often pontificate about the importance of due diligence when selecting strategies, particularly in the world of alternatives where approaches vary widely. Robust due diligence remains essential even when you have narrowed down your strategies to a small subset like multi-factor, quantitative long/short equity funds. For instance, a few basic questions should be asked: Is there a static exposure to factors or a dynamic one? Do all factors get equal exposure, or are some more heavily weighted than others? How much leverage is used? It’s hard to think that these things could matter all that much when all the funds have essentially the same strategy of exploiting factors, but as you can see below, it does. (This is the performance of six quantitative factor-based long/short equity mutual funds in the Morningstar Long/Short Equity Category during 2020.)
In a year when a generic multi-factor portfolio was down nearly 3%, one fund was up 5%, a few others were flat to down 5%, and two others were down more than 15% in a year the S&P 500 Index was up over 18%!
Given this is the third year in a row that has been challenging for factor strategies, what does performance look like over a longer time frame? As you can see, the dispersion is still very wide – process matters!
It’s a little risky to write this because I think it would be pretty easy to look at this and say, “why even bother with factor approaches?” The stronghold that recency bias has on humans is incredibly strong. And, you can check any flow report to see that it is no different when investing in quantitative factor-based strategies. Unfortunately, no one can predict when conditions may be more favorable to the style, but I have seen plenty of research that indicates conditions and investor preferences will eventually change. It may feel like valuations, quality, risk will never matter again, and that a handful of mega-cap growth companies will be the only winners forever; if that is the belief, then factor strategies probably aren’t the best choice. However, for investors that think factor investing approaches do have merit over time, it’s important to remain patient, as well as understand the details around the approach taken by your manager because as we can see from these return charts, it can make a big difference, and make weathering inevitable headwinds a little less difficult to stomach.
Read more in our last blog, Share Your Spare! >