Beyond the Dark Ages of Factor Investing

The following is a reprint of an article published on Actiquant.com in May 2018.

Factor investing is all the rage. Fama and French showed the way, many have followed, and now it’s all nailed down. It certainly seems that way when we see factors working as we think they should.

But what happens when they don’t? What happens, for example, when value stocks, those with more favorable (i.e. cheaper) price-to-something ratios, fare poorly? What’s your gut-level reaction?

  1. The market has taken leave of its senses and will eventually return to sanity?
  2. Sometimes value is in, sometimes it’s out, now it’s out.
  3. We screwed up and are not properly calculating value ratios–or are using the wrong ratios?
  4. All of the above.
  5. None of the above.

The correct answer is 5, none of the above. Value does not always work because it’s not supposed to always work. The same can be said of Quality, Momentum, Size, Liquidity or any other factors that have or might someday be identified.

Sure, there’s tons of empirical data in gobs of studies that supposedly show these factors to work. But what are they showing: true causation, or the happenstance of correlation that may or may not come from something significant and sustainable? Often, way too often, it’s the latter (a practice affectionately known as “data mining”).

Here is a draft study I did, written for users of Portfolio123, showing that factors should be used in combination, not simply because more things are better than one thing but because financial logic absolutely requires that different considerations (factors) must and can only work hand in hand with one another.

The Draft Study: Gerstein – P123 VSQ Factor Investing Study

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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