When multi-factor investing turns into an endurance test

Equity factors can deliver returns over time, but investors can go through times that try their souls

When multi-factor investing turns into an endurance test

The past several years have brought increased interest in factor investing, particularly multi-factor products that provide diversified exposure and more protection from cyclical risks. But even those strategies aren’t immune from drawdowns that could test their investors’ faith.

In a piece published by the CFA Institute, Nicolas Rabener, managing director of FactorResearch, noted that the most recent FTSE Russell smart beta study found 71% of investors using multi-factor products, up from 49% in 2018. But over the last 18 months, those exposed to such strategies have had to endure a reported near-20% decline in performance.

In an effort to determine how much pain investors should expect, Rabener sought to construct a historical context focused on long-short multifactor products. “Since early 2018, most of these products have lost money, with current drawdowns exceeding 20% in some cases,” he said. “As a consequence, some products have lost more than half of their assets under management (AUM).”

He then described a simple long-short portfolio based on US stock market data from the Kenneth R. French Data Library going back to 1926. Allocated equally to Value, Size, and Momentum factors, the portfolio consists of two parts: a long sleeve with cheap, small, and outperforming stocks; and a short sleeve with expensive, large, and underperforming ones. The two portions are created by sorting the top and bottom 30% of stocks based on each factor’s definition.

“Not counting transaction costs, this multi-factor strategy significantly outperformed the US stock market over the last 90 years,” Rabener said, noting that the portfolio struggled only during the Great Depression between 1929 and 1939 and over the last 10 years.

Because of the partial hedge that long-short portfolios have, they’re assumed to bear less risk compared to equity markets as a whole. A truly market-neutral strategy, with the allocations to the short portfolio matched to those in the long one, is expected to have minimal drawdowns.

“Yet the market-neutral, multi-factor portfolio’s declines have exceeded 30% at times,” he said, noting concerted poor performance among the three factors and minimal protection from diversification during a drawdown from 1939 to 1944.

The current drawdown, he added, began in 2008 and was fueled primarily by a crash in the Momentum factor during the global financial crisis; it has yet to restore itself to its previous peak. While drawdowns of at least 30% for long-short, multi-factor portfolios have been fairly rare since 1926, Rabener noted that “smaller declines were fairly common.

“Overall the takeaway is clear: Harvesting returns from equity factors is no free lunch and requires as much perseverance as investing in the equity markets,” he said.

Contextualizing the current performance of the long-short, multi-factor portfolio, which has amounted to a roughly 17% drawdown, Rabener pointed to deeper declines during the Great Depression, and similar ones from the tech bubble of 2000. But while it only took two years for the portfolio to recover in past drawdowns, the most recent drawdown has seen it go over 10 years without being able to reclaim its previous peak.


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