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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?
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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
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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
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LowVol: success ratio is 50%
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Value: success ratio of more than 60%
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Momentum: mixed results
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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%
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Important Information
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