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We usually focus on how to make a good investment strategy even better, but in recent research we looked at how to make it worse.
In previous research we found a 6% return difference between good and bad low-volatility strategies (Blitz, Hanauer and van Vliet, “Beauty and the beast of low-volatility investing”, Robeco research paper, February 2015). In recent research, we did a similar exercise for value and momentum strategies.
Our research and live track records show that it is possible to create factor strategies that are superior to generic approaches. At Robeco we eliminate unrewarded risks, prevent going against other established factors, maximize diversification benefits, and avoid unnecessary portfolio turnover. This made us wonder whether we could also construct inferior factor strategies. In other words, factor strategies that are not designed to outperform, but to underperform a generic approach. This started out as a kind of joke, but the results turned out to be quite interesting.
The comparison between good and bad factor strategies is relevant for various reasons. For one, the bigger the gap between good and bad strategies, the more important it is to be selective when the objective is to capture factor premiums. Also, our analysis helps to better understand what differentiates a successful factor investing approach from an unsuccessful one. Finally, distinguishing between good and bad factor strategies may shed new light on the performance of generic factor strategies. These basically contain both types of stocks, although not necessarily in the same, constant proportion.
‘Clearly, not all value stocks and not all momentum stocks are equally attractive’
In our research, we found that different types of value and momentum stocks exhibit very different performance characteristics. A value approach which incorporates some momentum and risk considerations tends to outperform a generic approach, but a value approach which intentionally goes against these factors significantly underperforms. Similarly, a momentum approach which incorporates some value and risk considerations tends to outperform a generic approach, while a momentum approach which intentionally goes against these factors significantly underperforms. Over the past decades, the two approaches show a difference in risk-adjusted return amounting to an astounding 5-7% per annum.
Based on these results it is clear that investors should not buy stocks merely based on one particular factor, but also take into account other factors that are known to have a large impact on returns. Generic factor strategies tend to contain a time-varying mix of stocks that are attractive and stocks that are unattractive on other factors. On balance, the exposures of a generic factor strategy to other factors are not necessarily neutral, but can also be unattractive. The Robeco approach towards factor investing effectively prevents going against other established factors.