Equity multi-factor long-short style factors - When will the odd performance return to normal?

Style (long-short) factors have a long history of positive performance but are time-varying. The classic long-short equity style factors of size, value and momentum are readily available through the Ken French data website. These factors can be bundled into portfolios to show their long-term benefit. The researchers at Factor Research looked closely at an equal-weighted portfolio of the value, size, and momentum long-short style factors over a long horizon from the 1920’s to the present in a post on the CFAInstitute Enterprising Investor website. It highlights the unusual behavior of these factors over the last ten years.

Holding a long-short factor portfolio provided a good positive return with minimal drawdowns over close to 100 years. However, there were two periods of strong drawdowns when the factor approach was ineffective: one, the period of the Great Depression, and two, the current post Financial Crisis period.

The breakdown during the Great Depression would seem to make sense. There was no hiding from the financial dislocations of firm during this period. It took the revival of the economy post-WWII to see returns moves to more normal behavior.

The current deep and prolonged drawdown is a little harder to explain given that these style factors are often associated with behavior biases that still seem to persist. There is limited evidence that financial flows have been the cause for this unexpected return persistent. The spreads based on factors such as P/B or P/E for value vary over time but there is not enough evidence to suggest that these styles cannot generate an expected return difference between extreme as theorized.

There has been a clear return advantage for large over small cap return premia and higher P/E stocks over low P/E names. The momentum factor, which has a tendency for “crashes” during periods of extreme market stress, has not been able to reverse the underperformance. The result has been an extended drawdown with other factors like low volatility being more attractive.

Given the long history of style factor return persistence, the play for investors is to look for these well-known style factors to move to normality. It is not clear what will be the driver for a return to normalcy, but investors should favor this over a structural change.

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