Tuesday, July 2, 2019

Be careful with factor timing - Mutual fund investors destroy value by trying to time

Factor based mutual funds generate positive alpha versus actively managed mutual funds. Factor investing should capture the underlying risk premia associated a factor which will be independent of any stock-picking skill. These excess returns may not seem surprising given the poor performance shown by most active mutual fund managers. The performance bar is pretty low; however, a recent study looks more closely at the investment behavior of mutual fund buyers. In the paper, "Factor Investing From Concept To Implementation" Eduard van Gelderen, Joop Huij, and Georgi Kyosev calculated the weighted IRR for factor funds based fund flows to determine whether investors have any skill timing these factors. This can be another source of return.

The sad result is that the aggregate behavior of investors takes money away from factor fund performance. This result seems to be the classic fund chasing behavior of investors. Investors buy funds based on past performance and usually switch factors and factor managers at the wrong time. 

The simple table below shows the difference between Fama-French factors, mutual fund factor managers, and investor performance. There should be a drop in performance from transaction costs and fees but there is further return declines based on investor decision-making. Nevertheless, there is value from just creating a buy and hold bundle of factor funds.  

Don't overthink the factor investing. Hold a bundle of factors and resist the urge to actively manage. While there are other studies that suggests there can be some value-added from timing, the general conclusion is that at best, it is not easy. If an investor cannot identify his timing skill beyond his own confidence, focus on just holding a diversified bundle and let these risk premia generate their long-term returns.

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