Only a handful of factors are statistically significant and deserve consideration from investors seeking risk premia in equities, according to Research Affiliates.
The proliferation in recent years of factors beyond the traditional four—value, small-cap, momentum, and market risk—has muddied investor strategy, argued firm co-founder Jason Hsu and senior vice president Vitali Kalesnik in a paper.
“We are concerned with the relentless onslaught of shiny, exciting, and sexy new factors introduced by bright-eyed, bushy-tailed young financial engineers,” the two Ph.D holders wrote.
Moreover, they warned many of these “data-mined” factors offer no future premia.
The researchers found 49% of 600 examined factors produced zero to negative additional return, which indicated “investing based on the identified factors is only ever so slightly better than tossing coins.”
Among the “zoo of factors,” Research Affiliates said older and well-understood factors such as value, low volatility, momentum, market risk, and illiquidity risk proved statistically important. There were marginal results found with newly identified anomalies such as default risk and return-on-equity.
The ability to weed out ineffective factors among a sea of anomalies is especially important for smart beta strategies, the report said.
According to Hsu and Kalesnik, investors should focus on factors that have survived over time, function globally, and stand up against minor changes in definition and construction to secure a true return premium. These factors also retained a “credible reason” to perform persistently.
Once investors determine which factors to employ in their equity portfolios, the authors said they should ascertain which premia could be accessed via low cost indices and which require active managers.
The report found the momentum and illiquidity premia necessitated active managers with sophisticated trading skills, while value and low beta premia could be captured through index products.
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