Evidence-Based Investing The Case of Factor Investing

by Joop Huij, PhD

For professional investors

1

Case for Evidence-Based Investing?

Investments industry lags other knowledge-based industries in

incorporating academic insights

˃ E.g., Medicine has embraced Evidence-Based Practice in the 1990s

˃ EBP enables learning in complex environments with lags between action-

response and noisy signals.

˃ EBP incorporates quantitative methodology in the “art” of clinical practice

˃ EBP helps to give up unproven practices (e.g., bloodletting)

2 Feb-14

Source picture: Wikipedia Hypothetical example of EBM

What is Factor Investing?

3 Feb-14

Risk-adjusted

expected return

low

high

Legend

Government bonds

Credits

Equities

Government bonds

Credits

Equities U.S.

Equities Europe

Equities Japan

Government bonds

Credits

Equities

Eq. Hi.Val.

Eq. Lo.Val.

Eq. Hi.Mom.

Eq. Lo.Mom.

Eq. Hi.Vol.Eq. Lo.Vol.

Government bonds

Credits

Equities

Equities High Value

Equities High

Momentum

Equities Low Volatil ity

Government bonds

Credits

Equities U.S.

Equities Europe

Equities Japan

1. Traditional strategic asset

allocation

2. Traditional break-down in

regions

3. Search for skilled managers

(alpha)

4. Factor premiums drive alpha 5. Strategically allocate to factor

premiums

Exhibit A: Literature on Asset Pricing

Numerous studies show that

certain groups of stocks have

historically earned excess returns

> Value vs. growth stocks

> Past winners vs. losers

(momentum)

> Low volatility vs. high volatility

Implication: passive investing is

inefficient

> The capitalization-weighted market

portfolio simply invests in all

stocks, i.e., attractive as well as

unattractive ones

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Market

ValuePast winners

Low vol

Growth

Past losers

High vol

0%

1%

2%

3%

4%

5%

6%

7%

8%

9%

10%

10% 15% 20% 25% 30%

His

torica

l exc

ess

retu

rn

Historical volatility

Exhibit B: Norges study

Ang, Goetzmann & Schaefer

(2009) study for Norwegian

reserve fund

> Historically, active management of

the fund added value

> Most of this added value can be

explained by implicit exposures to

systematic factors (betas)

> These factor exposures arise from

bottom-up manager selection

> Their recommendation is to

adopt FACTOR INVESTING

instead: allocate to proven

factors in a top-down, explicit

manner

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Exhibit C: Factor Investing pioneers

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Rebuttal A: Trading costs

Academic factors are based on hypothetical stock portfolios

> Close prices are used

> Dividends are assumed to be fully reinvested

> Trading costs are typically ignored

> Several studies argue that premiums are not robust to trading costs

7 Feb-14

Source: Avramov, Chordia and Goyal, Journal of Finance, 2006

ACG study shows that

the short-term reversal

premium

> is concentrated in

illiquid small cap

stocks

> is negative after

trading costs

Rebuttal B: Adaptive Market Hypothesis

Adaptive Market Hypothesis

> Premiums might be priced/arbitraged away after public dissemination of

anomalies

> Several studies argue that premiums of some of the factors have become

smaller over time

8 Feb-14

Source: STR series from Kenneth French data library

Setup study, data & methodology

Study by Huij and van Gelderen (2013) :

˃ Sample of 6,800+ U.S. equity mutual funds back to 1990

˃ Data from Morningstar and Prof. French

˃ Return-based Style Analysis

˃ Focus on low-risk, small cap, value, momentum, reversal styles

˃ Outperformance measured relative to U.S. market portfolio

˃ Returns are net of costs (fees, trading costs, administration costs, …)

Main objective: investigate if Factor Investing funds show better

success ratio than the control group

Can be downloaded from:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2295865

9 Feb-14

LowVol: success ratio is 50%

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Value: success ratio of more than 60%

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Momentum: mixed results

12 Feb-14

Follow-up empirical analyses

Multivariate regressions controlling for other factors yield that results

are economically and statistically significant.

Factor investing funds:

> earn 0.6-0.7 standard deviations above average fund

> earn net alphas of 56-119 basis points

> have success ratios of 61-67%

These funds also exhibit outperformance over second sample period

after public dissemination of academic results

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Value added of factor diversification

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Conclusions

> Since the 1990s a substantial number of investment funds is

engaging in factor investing

– Study for GPF and Robeco research recommend intentional and

efficient allocation to factor premiums.

> Factor Investing funds do significantly better than their peers:

– 0.6-0.7 standard deviations above average fund

– Net alpha of 56 to 119 basis points

– Success ratio of conventional active funds is only 20%; success ratio of

Factor Investing funds is 60-70%

15 Feb-14

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