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Factor Investing Wisdom?

Posted in Equity Premium, Momentum Investing, Size Effect, Value Premium

How should investors think about stock factor investing? In his April 2016 paper entitled “The Siren Song of Factor Timing”, Clifford Asness summarizes his current beliefs on exploiting stock factor premiums. He defines factors as ways to select individual stocks based on such firm/stock variables as market capitalization, value (in many flavors), momentum, carry (yield) and quality. He equates factor, smart beta and style investing. He describes factor timing as attempting to predict and exploit variations in factor premiums. Based on past research on U.S. stocks mostly for the past 50 years, he concludes that:

  • Investors should focus on factors best supported by out-of-sample, multi-asset class evidence and economic theory.
  • Investors should diversify across selected factors cost-effectively.
  • Investors should understand that factors are increasingly well-known, and factor portfolios are therefore increasingly subject to crashes driven by position crowding.
  • Variations in factor premiums (including the equity risk premium) are largely unpredictable. There may be a modicum of predictability when premiums drift to unprecedented levels. Even then, factor timing bets should be small.
  • Factor premiums are currently within reasonable historical ranges.

In summary, evidence suggests that factor investing (like the stock market in general) is strategic, with very little tactical predictability, and subject to crowding crashes.

Cautions regarding conclusions include:

  • The paper does not explicitly quantify evidence for assertions.
  • Economic theory is generally weak because (1) financial markets are complex/adaptive and (2) controlled, realistic testing is problematic.
  • Factor testing outside of U.S. stocks is sparse and sample-limited.
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