Overcrowding and other fallacious concerns about factor investing

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Factor investing is popular. As frequently happens when the consensus advocates a particular approach to investing and it becomes part of mainstream thinking, some pundits express the view that it’s being overdone and will inevitably be spoiled by its success. Other investment fads have suffered when the bandwagon became overcrowded, so such concerns cannot be dismissed out of hand. Factor investing however is much more than a fad. Some declinations of the strategy may not fulfil everyone’s expectations but in our view the overall approach is very much here to stay.

A nihilistic view of financial markets that finds appeal with some observers (perhaps because it generates a constant news-stream) is that any successful investment idea is bound to disappear, either by being arbitraged away (by hedge funds and other ‘smart money’) or through sheer overcrowding resulting in lower returns and disappointment.

Implicitly, such a view supposes that markets are broadly speaking, rational, even if there may occasionally be quirks and imbalances that create short-term opportunities. This philosophy does not run entirely counter to the Capital Asset Pricing Model (CAPM) of Jack Treynor, William Sharpe, John Lintner and Jan Mossin, but rather it inserts a small caveat to it, over the short-term.

Factor premiums are however not short lived

We have proof that these premiums have existed over many decades and under very different market conditions. This means that financial markets are on average wrong in their evaluation of the returns of securities if we try to apply the CAPM. This is due to cognitive biases – humans being prone to unpredictable behaviour, to overreaction or slumbering inaction, to mania and panic. It’s the foibles of human behaviour that, in my view, explain the existance of factor premiums.

As long as people have the last say on investments such cognitive biases will continue to generate factor premiums. At the core of the smart beta philosophy is the idea that some factor exposures are right and some are wrong, and that it is by keeping portfolios exposed to the right factors that investors can increase their risk-adjusted returns (see ‘The four cardinal virtues of quantitative management’ for more on the philosophy behind smart beta).

Why market capitalisation indices remain the reference for benchmarking investment performance

If all investors wanted to invest in one same strategy they would end up investing in a market capitalisation strategy. This is the reason why market capitalisation indices remain the reference for benchmarking investment performance. The good news however is that its highly unlikely that all investors ever simultaneously decide to consider pursuing the same strategy, e.g. smart beta: some investors simply buy stocks on account of their stories or their popularity.

We can also reject the notion of global overcrowding in factor investing by looking at the size of the smart beta market. Even an optimistic view of its development puts it below 10% of the global asset management industry, while market cap indexing is, by all standard measures, above 50%. In some financial markets such as emerging equities, it is the market capitalisation indices that are overcrowded. As Cliff Asness puts it, smart beta is like a theatre – overcrowding could become dangerous if there were to be a fire – but the theatre’s still empty.

None of this means that the world of smart beta strategies will be problem-free. Some strategies rely heavily on smaller capitalisation and illiquid stocks. Very large flows in or out of such specific strategies can strongly impact their short-term excess returns.

In conclusion, it is important to keep liquidity in mind when investing in any strategy, but the ultimate global reach of factor investing extends far beyond that of any of the specific strategies related to it. It’s for this reason that we believe factor investing truly represents a lasting revolution rather than an ephemeral revolt against the dominance of market capitalisation indexing.

Etienne Vincent

Global Head of Quantitative Management

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