A new study from Scientific Beta entitled “The Risks of Deviating from Academically Validated Factors” highlights the dangers of not adhering to academic consensus when it comes to factor investing. Among the key points of the study:
- Factors used in investment practice show a stark mismatch with factors that have been documented by financial economists.
- Commercial factors are based on complex composite definitions that offer maximum flexibility. Providers use this flexibility to seek out the factors with the highest performance in a given dataset.
- Such practice allows spurious factors to be found. Spurious factors work well in a small dataset but will be useless in reality. Therefore, many factors that appear in popular investment products and analytic tools are likely false.
This type of practice leads to the presentation of in-sample performances that have very little chance of being reproduced out of sample. This in turn calls the usefulness of factor investing into question, even though factor investing is a serious and robust source of superior long-term risk-adjusted performance when it respects the academic research that justifies its existence and that many factor providers continue to ignore.
Indeed, and unfortunately, even though many providers claim their factors are grounded in academic research, two important conditions to support this claim are often not fulfilled:
- The factor definitions should have been used and validated across different independent studies and
- A risk-based explanation should support the existence of the factor.
Without these assurances, there is no reason to assume the persistence of the factor.
Commenting on the study, Professor Nol Amenc, CEO of Scientific Beta, said, “Understanding the factor drivers of returns increases transparency and allows investors to formulate more explicit investment choices. However, being aware of exposures to useless factors, which have no reliable link with long-term returns, is pointless. For a meaningful contribution to the ability of investors to make explicit investment choices, factor investing should focus on persistent and externally validated factors. It is time to recall the good idea of factor investing.”
The white paper can be accessed through the link below:
The Risks of Deviating from Academically Validated Factors, Scientific Beta White Paper, February 2019.