Is factor investing a bubble?

René M. Stulz

Agenda

• Present at the creation: A historical perspective

• Are there 447 factors? • Demand and supply for factor

exposures• Risks of factor investing for investors

and the economy• Is there a bubble?

Historical perspective

MIT, 1970s

• Merton develops the ICAPM.• Key insight: Investor welfare does not depend only

on wealth.• Example: Investors may be worse off if interest rate

is low – a bad state of the world. • Implication: Some investors want to hedge against

bad states of the world so that assets whose return is high in bad states of the world have higher expected returns.

Journal of Finance, 1992• Accepted for publication Fama/French,

The cross-section of expected returns.• 17,467 Google citations. • Size and Value explain cross-section

well; beta does not.• Long-short factor portfolios earn

premiums that are compensation for risk.

• Consistent with ICAPM.

Journal of Finance, 1994• Lakonishok, Shleifer, Vishny,

Contrarian investment, extrapolation, and risk

• Argue that factor premiums are not compensation for risk but instead reflect characteristics that investors value.

• Reflect behavioral biases.

Since then: All anomalies (red), unique and published (green)(Hou, Chen, Zhang)

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2016

Why so many?

• Good way to get into journals for academics. That’s how they get tenure and raises.

• Most don’t hold up if micro-caps are removed from sample (Hou, Chen, and Zhang).

• Most don’t hold up if one accounts for publication bias and weaken post-publication (Schwert, McLean and Pontiff, Hou, Chen, and Zhang).

• Still, there is a large number of anomalies that survive even then.

Rational or irrational?

• Not much progress in the rational/irrational debate.

• Most anomalies accounted for by recent models:

• Fama-French five-factor model; • Hou, Chen, and Zhang four-factor model.

• Explaining anomalies with anomalies?

Does it matter where premiums come from? • Investors who care less about a risk or a

characteristic than the market as a whole can make themselves better off by bearing more of that risk or holding more of that characteristic than the typical investor.

• It does not matter where the compensation comes from.

• Future premiums are the ones that matter for investors.

Factor premium persistence

• Widespread belief that rational premiums are more robust.

• Not clear because demand and supply affects all factor premiums.

• Good reason to believe that over time demand for stocks that earn higher expected returns increases and supply decreases, so that premiums fall.

Demand and supply of factor exposures

Factor premium

Quantity

Demand from investors

Supply by firms

P2

P1

Limits to demand for factor exposures• There are limits to the demand for factor

exposures:• May require short-sales, but ability to short-sell is

limited. • May require leverage. • May require positions in high transaction cost stocks. • Imposes loss of diversification. • Can have extended periods of poor returns.

Demand shifts

• Demand can shift to the right as limits to arbitrage decrease and hence decrease factor premiums:

• Increases in market liquidity.• Changes in the technology for short-selling. • ETFs.

• Demand can shift to the right or to the left as investors find a risk more or less costly or value a characteristic more or less.

• If academia does its job, demand should shift to the right. As more investors know about compensation for risk or characteristics, demand should shift.

Supply of factor exposures

• Corporations supply factor exposures, but supply can slow moving.

• If a corporation’s exposure to a factor leads to higher cost of capital, supply of factor exposure will fall.

• Example of size. If being small involves a higher cost of capital, it pays for firms to merge. We would see fewer small firms.

• Example of low book-to-market firms. These firms have low cost of equity, so they issue more equity.

• These changes affect the supply of factor exposures.

Fewer listings than in 1975

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1000

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7000

8000

1975

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2015

No.

of l

istin

gs

number of listings

Average market cap increased sharply in constant dollars

-

1,000,000.00

2,000,000.00

3,000,000.00

4,000,000.00

5,000,000.00

6,000,000.00

7,000,000.0019

7519

7619

7719

7819

7919

8019

8119

8219

8319

8419

8519

8619

8719

8819

8919

9019

9119

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9419

9519

9619

9719

9819

9920

0020

0120

0220

0320

0420

0520

0620

0720

0820

0920

1020

1120

1220

1320

1420

15

Average firm marketcapitalization

Fraction of firms with low market cap (<$100 million in 2015 dollars)

0.000

0.100

0.200

0.300

0.400

0.500

0.600

0.700

1975

1976

1977

1978

1979

1980

1981

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1983

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1991

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Fraction of firms with lowmarket capitalization

Size effect

1963-2014: 0.58% (t=2.83)1963=1983: 1.16% (t=3.28)1983-2014: 0.21% (t=-0.84)

Source: Hou and van Dijk, Resurrecting the size effect, July 2017

The future

• As demand for factor exposures increases, factor premia must fall.

• Supply response from corporations: they will supply fewer exposures that increase their cost of equity.

• These mechanisms suggest lower factor premiums in the future.

• But: There are limitations to taking advantage of factor premiums: limits to short-sales, limited liquidity, taxes, and so on.

• Realized factor premiums are volatile, so that forecasting factor premiums is hard.

Risks of factor investing

• Fall in factor premium.– Stocks long the exposure increase in value– Short-run dislocation if investors run away from the stocks– Stocks short the exposure decrease in value. – Short-run dislocation if investors close positions quickly.

• Increase in factor premium.– Stocks long the exposure decrease in value.– Stocks short the exposure increase in value.– Whipsaw!

• There is a diversification cost.

Is it a bubble?

• Only in the identification of factors by academics.• In practice, it is a sound approach supported both by theory

and empirics.• Unfortunately, in the investing world, expected alpha is

inversely related to the number of smart asset managers trying to produce alpha.

• If there is too much enthusiasm for factors, there must be some good stock picking opportunities.

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