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To the best of our knowledge, no study has been conducted on the added value of innovative investment strategies that incorporate academic insights. As a result, we do not know how many investment managers have incorporated academic insights or how successful they are. We have researched the topic to fill this gap in the literature.
Numerous investment managers claim to have incorporated insights from academic studies. For example, after the publication of the study of Fama and French in 1993, many investment managers claim that they have adopted investment styles based on the Fama-French small cap and value factors. Although there are a few studies that evaluate the performance of specific investment vehicles such as value funds, there is no all-encompassing study that investigates the more general question of whether the adopters of academic knowledge gain excess returns, or under which circumstances application of this knowledge is successful.
We researched the issue. We restricted ourselves to factor investing strategies, as their application can be measured reliably. We evaluated the monthly performance of a large sample of US equity mutual funds over the period from 1990 to 2010, using a regression-based method to indicate whether the funds follow factor investing strategies based on the low-beta, small cap, value, momentum, short-term reversal, or long-term reversal anomalies. We obtained return data for these anomalies from the webpage of Ken French. We found that a significant number of funds (roughly 20% to 30%) have adapted small cap and value investment strategies. Only a small number of funds (1% to 6%) follow low-beta, momentum, and short-term and long-term reversal strategies.
In our study, we find evidence supporting the added value of funds adopting low-beta, small cap, and value strategies. We also find that the excess returns earned by these funds are sustainable and have not disappeared after the public dissemination of the anomalies: not only do we find a positive relation between fund performance and the adoption of factor investing strategies during the first decade of our sample, but we also find this positive relation to be present over the second decade. This implies that investors do not have to worry that the added value of incorporating new knowledge is only short-lived and that mispricings are quickly arbitraged away once more investors adopt the knowledge.
We do not find consistent evidence of the added value of funds adopting momentum and reversal strategies. For funds engaging in momentum strategies, we find mixed evidence, and for funds engaging in short-term reversal strategies, we even find evidence of negative excess returns. We attribute these mixed results to the very small sample size of momentum and reversal funds in our study.
The outperformances of funds adopting low-beta, small cap, and value strategies are not only significant from a statistical point of view, but are also economically highly significant. Against the market index, small cap and value funds deliver average alphas of 56 and 119 basis points per year, respectively, after costs. The returns of low-beta funds are indistinguishable from the market return, but these funds show significantly lower levels of risk.
Having established the added value of incorporating academic insights, we ask ourselves to what extent the incorporation of a certain academic insight adds value in addition to the value already added by another insight. For example, if a fund already engages in a small cap investment strategy, how would the likelihood of outperformance change if the fund also engaged in a value strategy? The results of the analysis are presented in the table. The abbreviations 1_FAC, 2_FAC and 3_FAC indicate whether a fund is exposed to one, two or three factors, respectively. We have no fund in our sample that is exposed to more than three factors.
The table shows that the more factor strategies to which a fund is exposed, the higher its alpha and success ratio. For instance, non-factor investing funds have an average alpha of −189 basis points and a success ratio of 20%. For comparison, funds that are exposed to one factor have an average alpha of −26 (= −189 + 163) basis points per year and a success ratio of 51% (= 20 + 31). Funds that are exposed to two factors have an average alpha of 145 basis points and a success ratio of 68%; and funds that are exposed to three factors have an average alpha of 164 basis points and a success ratio of 78%. This clearly shows that incorporation of a certain academic insight can have incremental value above and beyond the added value of another insight.