by Isaac Presley, CFA
In a series of articles about factor investing we’ve defined what we mean by factor investing, we listed the factors and examined their performance, and last time we examined how a strategy can still work when everyone knows about it. The next question we get is, if a strategy works, why doesn’t everyone do it? Why doesn’t everyone earn a factor premium?
This is a great question to ask about any investing strategy and the answer is twofold: First, some people remain skeptical about systematic investing strategies in general. Many continue to think, no doubt encouraged by the plentiful marketing dollars of Wall Street, that traditional stock picking is the only way to outperform. Next, even those pursuing an evidenced-based strategy don’t tend to stick with it over time. This includes both individual and institutional investors.
Unknown or secret strategies aren’t plentiful. There isn’t some holy grail of investing to be found that magically delivers alpha (i.e., outperformance). What matters is having enough confidence in your strategy that you can stick with it through various market cycles. As Brendan Mullooly of Mullooly Asset Management recently wrote, “If your investment strategy is based upon strong evidence (I hope it is!), you need to hang in there.”
But, sticking with your strategy can be difficult as earning a premium over other investors requires being different than other investors. This can be painful, especially when a strategy is out of favor. And just because everyone knows about a strategy, it doesn’t make it easy to get the premium. Phil Huber, the Chief Investment Officer for Huber Financial Advisors, puts it like this: “An unfortunate truism in our industry is that investors tend to abandon ship on an asset class or strategy right around the same time they should be piling into it.”
It’s easy to make the claim that investors don’t stick with their strategy, and this probably makes intuitive sense, but are there any data to back this up?
Let’s take a look at a few examples from both individual and professional investors. Then we will conclude with a few ideas on how, as investors, we can stick with our strategy.
In their book Adaptive Asset Allocation Butler, Philbrick, and Gordillo write the following:
However, data on investor behavior suggest that this investor is unlikely to stick with a strategy for much longer than four or five years. From Dalbar’s 2014 Quantitative Analysis of Investor Behavior Report, we know that investors in stock and bond mutual funds tend to stick with their strategy for about three years, while diversified investors have historically held on for almost five years.
So, on average investors are only willing to maintain a strategy for three to five years. What harm can this do?
Meb Faber, the CIO of Cambria Investment Management looked at a strategy of investing in the asset allocation that worked best over the last decade and holding it for the next decade—something an impatient investor looking in the rearview mirror may do. According to Meb, this strategy “would reduce your return by 1.5% per year.”
Clearly for individual investors, sticking to your strategy is paramount to success.
But it’s not just retail investors that fail in maintaining their strategy over the long run. Professional investors make the same mistakes as well.
Institutional Investment Managers Don’t Stick to Their Strategy Either
Professional investors are just as impatient and backward looking as individual investors. In a 2008 study published in the Journal of Finance, we see that on average institutional (i.e., professional) investors allocated to managers with excess returns in the prior three years. The problem is, after the manager change the excess performance turns into a performance drag—clear evidence of performance chasing, impatience and not sticking with one’s strategy.
One large money manager getting press recently due to their recent struggles is GMO. The firm invests in a contrarian-style, meaning they invest in areas presently out of favor and count on reversion to the mean; A difficult strategy for its investors to maintain during periods of underperformance.
From a recent article in Institutional Investor we see evidence of these so-called “sophisticated” institutional investors failing to maintain a strategy they committed to:
The lag in performance at GMO has caused a handful of U.S. public pensions invested across its strategies to put the firm on watch lists or terminate relationships completely. Firmwide assets sit at $99 billion, down from last year, when they hovered near $115 billion, and off substantially from 2007’s peak of $155 billion, according to Morningstar.
In May 2015 the $550 million Alameda–Contra Costa Transit District Retirement System, based in Oakland, California, unwound its tactical portfolio, which included GMO, citing performance. In March of this year, the $1.7 billion Milwaukee County Employees’ Retirement System terminated GMO’s $65 million mandate, also specifying performance.
The $12.1 billion Orange County Employees Retirement System in Santa Ana, California, has put GMO on its watch list; the firm manages $195 million for the pension.
And, according to Jake at the Econompicdata blog, GMO, despite a 16th percentile Morningstar rank in terms of fund performance over the last ten years, its investor performance only ranks 74th. The average investor in the GMO Benchmark Free Allocation III has underperformed the fund itself by 5.33%, 5.34% 4.15% over the last 3, 5 and ten year periods respectively according to Morningstar due to their poorly timed buy and sell decisions. Or put another way, these investors cost themselves 4%-5% by failing to stick with their strategy.
The data show that in aggregate investors have a hard time sticking with a strategy for the long-term. So, what can be done to make it easier and more successful, particularly as it relates to factor investing? A few thoughts:
- Realize going in that factor premiums don’t show up every year. While factors put the odds in your favor, even over rolling five year periods the value, size, and profitability factors only outperformed 77%, 64% and 92% of the time respectively according to Dimensional Fund Advisors.
- Extend your time frame. Institutional investors have a hard time sticking with a strategy because of the short-term nature of their reporting cycle—quarterly reporting to a board in most cases. Because the odds increase the longer you can stick with a strategy, don’t get caught up in short-term results. This is a unique advantage individual investor have over most institutions.
- Diversify your factor exposure. The factors don’t all work at the same time. By combining factors, you can still earn the premium but ideally minimize the amount you lag the market in the years in which any one factor doesn’t work out.
- Implement factors with an advisor. When things get dicey, it’s helpful to have a third party involved to keep you from making a rash decision.
- Know thyself. If you’re someone that isn’t seeking to enhance returns and are happy to take what the market in aggregate is giving you, that’s okay. Factor investing isn’t for everyone.
But, for anyone who is implementing a factor investing strategy, or any investing strategy for that matter, the key is discipline and sticking with the strategy long enough to give yourself a chance to earn the premium. To get outperformance, you have to be there when it shows up.