Factor Investing Tests Still Limited Despite Years of Data

With over 30 years of data at their disposal, you would think ETF providers offering factor-based products would have enough data to suffice for back testing, but it’s still not enough according to some market experts.

“While certain investing styles or factors have always been popular, it wasn’t until ETF providers rigorously tested for factor persistency that it became more mainstream,” wrote Forbes contributor Randy Brown, who has hedge fund and private equity experience. “However, one of the limitations of the current analysis is that it is mainly based on data from 1981 to 2011. While 30 years sounds robust, it doesn’t allow for reliable out-of-sample testing.”

Analytics firms Global Financial Data and Robeco looked at over 200 years of data in a variety of asset classes, including stocks, bonds and commodities. It also looked at six components of factor investing.

“Robeco back tested six investing factors: (1) Momentum (outperforming securities tend to continue to beat laggards), (2) Value (high dividend/income yield), (3) Carry (high current yield), (4) Betting against beta (low beta outperforms high), (5) Trend (12 month excess return is predictor of future) and (6) Seasonality (buying at certain times of the year),” Brown wrote. “It applied consistent testing methodologies, whereas existing research was based on a range of models.”

“Robeco’s research found low correlations between the six factors, implying they represent independent sources of risk and return,” he added. “Of the 24 factors investigated (four assets and six factors), 19 of those were highly significant.”

Nonetheless, smart beta ETFs have attracted over $900 billion in assets based on FactSet data. One place where investors can get started is quality.

In particular, the iShares Edge MSCI USA Quality Factor ETF (BATS: QUAL). QUAL seeks to track the investment results of the MSCI USA Sector Neutral Quality Index composed of U.S. large- and mid-capitalization stocks with quality characteristics as identified through certain fundamental metrics. The fund generally will invest at least 90% of its assets in the component securities of the underlying index and may invest up to 10% of its assets in certain futures, options and swap contracts, cash and cash equivalents.

Another fund to consider is the iShares Edge MSCI Intl Quality Factor ETF (NYSEArca: IQLT), which seeks to track the investment results of the MSCI World ex USA Sector Neutral Quality Index—it measures the performance of international developed large- and mid-capitalization stocks exhibiting relatively higher quality characteristics as identified through three fundamental variables: return on equity, earnings variability and debt-to-equity.

For more market trends, visit ETF Trends.