By Grant Engelbart, CLS Investments

Factors are powerful tools for managing risk and producing excess returns – a pretty consistent message across the financial blogosphere. However, after reviewing the data, it seems investors are underperforming. So, what gives? There are likely many reasons for investor underperformance, but I want to highlight a few that I think pertain to investors – both sophisticated and unsophisticated – who utilize factors. How do I know these mistakes can lead to underperformance? I’ve made them myself!

Ignore Valuations

Like any asset class or style, factors trade in ranges of relative valuations. This has been disputed in recent years, but evidence points to a healthy emphasis – or at least awareness – of the valuation level of factors relative to their histories.

An analysis of the MSCI USA Index “Big 5” factors, which we generally look at, illustrates this point. Simply using price-to-book as a valuation metric (we recommend a composite of several) relative to the parent index, we can determine what factors are trading above or below their historical ranges. One-year forward returns of factors trading below their historical relative price-to-book ratios are shown in the top row below, and those trading above their histories are shown on the bottom.

1-year-forward-return-01

Several important observations can be made from this simple analysis. First, factors are powerful! Forward returns in both periods are generally stronger than the parent MSCI USA Index. Valuations can be used to take full advantage of this power. Momentum is a high-turnover factor, but I find it interesting that forward returns using valuations as a guidepost are strong for momentum. This may point to the adaptation of the momentum index into value-oriented stocks and sectors at certain times, intersecting those two factors.

Chase Performance

Investors lose more often than not because of performance chasing. We have all seen the behavior gap, and many have attempted to quantify it. We can use historical returns to gauge future outperformance in factors. However, as more and more ETFs are brought to market and become the vehicle of choice for factor-based investing, I suspect we will see more evidence of performance chasing and its impact on future returns.

For an investor who believes in factors but doesn’t wish to make any tactical decisions amongst them, holding an equally-weighted basket of factor ETFs is a good idea, so that’s what we will use to gauge performance versus a performance chaser. Historically, if factors on average outperform for any duration from one month to one year, they tend to outperform the following (rolling) year. As we extend that window further, future outperformance starts to fade before it no longer holds.

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