Factor Investing from Concept to Implementation

Abstract

Mutual funds following factor investing strategies based on equity asset pricing anomalies, such as the small-cap, value, and momentum effects, earn significantly higher alphas than traditional actively managed mutual funds. The authors report that a buy-and-hold strategy for a random factor fund yields 110 basis points per annum in excess of the return earned by the average traditional actively managed mutual fund. However, they find that the actual returns that investors earn by investing in factor mutual funds are significantly lower because investors dynamically reallocate their funds both across factors and factor managers. Although factor funds have attracted significant fund flows over their sample period, it appears that fund flows have been driven by factor funds earning high past returns and not by the funds providing factor exposures. The authors argue that, rather than timing factors and factor managers, investors would be better off by using a buy-and-hold strategy and selecting a multifactor manager.

TOPICS: Analysis of individual factors/risk premia, portfolio construction, manager selection