Taking a step back first, let me provide a little background on our strategies. We are big believers in factor investing, but also recognize that there are many investors out there who are much smarter than us. So rather than try to reinvent the wheel, we have combed through every book and research paper we could find to identify factor strategies with a track record of beating the market over the long-term. The result of that effort is currently 45 factor-based models that run the gamut of investing styles, ranging from value to growth to momentum. Each of these models was selected because it had a long-term record of beating the market and was completely rules based. We run focused versions of these strategies which hold between 10 and 20 stocks in an effort to maximize the potential for long-term outperformance.
Despite their long-term successful track records, these strategies on their own each suffer from the same problem illustrated in the chart above that all active strategies do. They can’t do it consistently. On average, they underperform the market in about 40% of one-year periods, and even the most consistent among them underperform the market 30% of the time over a one year time frame.
By blending different strategies together, in theory we can reduce that underperformance by focusing on combining different types of strategies together (i.e mixing value, momentum, quality etc). This should serve to increase consistency of returns. But does it move us close to our goal of consistent annual performance?
To test this, I created every potential three strategy blend of our models that exists. With 45 strategies to choose from, that creates about 14,000 unique possible combinations. The goal was to find some combination of uncorrelated strategies that beats the market in every 12-month period.
This attempt, despite having the benefit of perfect hindsight, was a complete failure. Not one of these 14,000 potential combinations beat the market every year.
With 45 strategies to choose from that have a long-term record of beating the market, and assuming I could have known in advance which combination of them would have produced the most consistent return over the past decade, I still could not come up with one that beats the market every year. The best combination outperformed in 88% of one-year periods, and even that is completely unrealistic because I could have never identified that one combination out of 14,000 possibilities in advance.
The point of all this is that if this completely flawed test with the benefit is perfect information still didn’t beat the market every year, then it just isn’t possible, and any investor following an active strategy needs to incorporate this fact into their expectations from the outset. And it’s not just one-year periods where underperformance is a problem. As the chart above shows, the same is true for three-year periods, five-year periods, and even ten-year periods. The odds go down as the period gets longer, but the only period in the entire chart that showed no underperformance historically was momentum over 20 years.
The other point to understand is that every decade is different. So even if I could have found a strategy that worked in 100% of twelve-month periods in the past decade, which was dominated by growth and momentum, it would be very unlikely to work in the next decade, where different types of stocks will likely outperform.
Everyone wants a perfect strategy. Everyone wants to beat the market every year. The reality, though, is that just isn’t possible. If you want to invest actively, there is perhaps no more important fact than that to accept from the outset. The good news is that even if you can’t beat the market every year, there is a strategy that guarantees you will meet its returns 100% of the time. That strategy is indexing and it offers a superior option for those who can’t handle the periods of underperformance.
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I remain a big believer in active factor-based strategies and their ability to beat the market in the long-term. They will just never do it consistently and only those who recognize that and can endure the pain that comes with it will ever realize that potential.
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