Factors, factors, factors. Everyone seems to love factors these days.

Why?

Because they have exhibited high returns in the past and investors love high returns.

But just because factors have outperformed over long periods of time in the past doesn’t mean they outperform all of the time. Not even close.

All factors have experienced multi-year (and sometimes longer) periods of underperformance. All factors will face such periods again in the future.

Few investors want to envision such periods before investing in factors. This is understandable – who wants to think about losses or underperformance when buying a new investment. It’s much more fun to stare at the long-term performance chart (up and to the right) and assume such gains were easily achieved.

But that is not reality.

The reality is that factor investing is hard, requiring both fortitude and faith. You need fortitude to ride out inevitable bad times and faith to believe the good times will come again.

The only way to have fortitude and faith in my view is to understand what drives factor performance. Knowing only about a factor’s strong returns is not enough; you need to understand the why in order to have any chance of sticking with it in the future.

Five of the most prominent factors are:

• Market (stocks beat risk-free bonds)
• Value (cheap beats expensive)
• Momentum (strong recent returns beats weak recent returns)
• Low Volatility (low volatility beats high volatility)
• Size (small beats large)

All have done well in the past. The key question is why.

There are two schools of thought when it comes to explaining factor performance: risk and behavior. The former posits that factor premiums are compensation for taking on more risk. The latter posits that factor premiums are a result of investor behavior (errors and constraints).

Let’s run through some of the “why” theories for each of the five factors…

Market

Stocks outperform risk-free bonds over time. Why?

• Economic uncertainty: the value of future cash flows is uncertain due to fluctuations in the overall economy.
• Long-run growth risk: small downward revisions in long-run growth can have large changes in stock prices.
• Borrowing constraints: young investors with low wages/assets, who should be holding equity, are prevented from doing so due to borrowing constraints (they cannot borrow to purchase equity).
• Myopic loss aversion: investors are more sensitive to losses in wealth than gains and take a short-term (myopic) view of their portfolios.

Value

Cheap stocks beat expensive stocks over time. Why?

• Higher business cycle risk: value stocks are more adversely affected by negative business cycle shocks than expensive (growth) stocks.
• Higher distress risk: value stocks have more credit risk.
• Long-term mean reversion (overreaction): investors overreact to “unexpected and dramatic” news events, creating a deviation from fair value, after which “losers” (value stocks) outperform “winners” over the following 36-months.
• Glamour stock, extrapolation, and recency bias: investors overpay for so-called “glamour stocks” with strong recent growth/performance and underpay for stocks that are boring, have poor returns, and unloved. Market participants consistently overestimate future growth rates of glamour stocks and underestimate growth rates of value stocks.

Momentum

Stocks with stronger recent returns (1-month to 1-year) outperform stocks with weaker recent returns. Why?

• Higher tail risk: momentum strategies have incurred infrequent but large losses (left skewed distribution).
• Higher downside risk: momentum stocks are more highly correlated with the market when the market is declining.
• Overreaction: investors have a delayed overreaction to stock-specific news, chase past returns, and exhibit herding behavior.
• Underreaction: investors underreact to stock-specific news due to an anchoring bias or gradual diffusion of information.
• Disposition effect: investors hold on to losers too long and sell winners too soon.

Low Volatility

Stocks with low volatility outperform stocks with high volatility. Why?

• Lottery effect: investors overpay for volatile stocks in the hopes of getting rich quick.
• Overconfidence effect: overconfident investors have a preference for high volatility stocks.
• Representativeness: investors overpay for high risk stocks because they focus on winning growth stocks (ex: Amazon, Facebook) and ignore the many speculative investments that fail.
• Leverage aversion: many investors are constrained from using leverage or are unwilling to use it. These investors bid up high beta assets. (Note: in our research paper on moving averages and leverage, we discuss this in detail).

Size

Small cap stocks outperform large cap stocks. Why?

• Higher risk: small caps are more likely to be marginal or distressed firms (low production efficiency and high financial leverage) than large caps and have higher systematic risk.
• Liquidity: small caps are less liquid than large caps.
• Transparency: small caps are less transparent with less information available than large caps.
• Less investor attention: large caps are covered by nearly three times as many analysts as small caps, with many small caps having no analyst coverage at all.

Understanding the Why

The current research on the why is not the final word by any means. There is much disagreement among academics and practitioners over what really drives factor returns. Some prefer risk-based explanations, others prefer errors-based (behavioral), and others still prefer some combination (they are not mutually exclusive). The debate is forever changing and expanding over time as new evidence comes in – as it should.

I’m pretty sure we’ll never have a simple, definitive “reason” for factor premiums, but that should not dissuade investors from attempting to understanding why they hold something.

For this understanding is critical when investors need it most: during the many hard times that factors are out of favor. During good times when your factor is going up or outperforming, that fact alone seems to be all that matters. But when your factor is going down or underperforming, you need more of a reason to hold on. Investors are much less likely to sell something if they understand why they owned it in the first place.

That understanding helps give you the fortitude to stick with factors for the long-term (no, 6-months is not the long-term), the time frame necessary to truly benefit from them. And given the painful cyclicality of all factors (there is no free lunch), you will need a lot of it, which is a strong argument as to why factor premiums have persisted (rewards patient,resilient long-term investors) and have not been arbitraged away (if it worked all the time, money would flow endlessly into a factor until its premium was eliminated).

But fortitude is not enough. You also need faith. Faith that the drivers of factors are real and that they will continue in the future. That faith will be tested when you need it most, when a factor is down or underperforming. Without it, you have no chance of benefiting from even the world’s best strategy because you will abandon it at the first sign of real weakness (which all of the best-performing strategies have at one time or another).

Before you invest in a factor, take the time to understand the why. Then ask yourself if you really have the fortitude and faith to stick with it when it’s down.