Factor Investing Risks - They Are Variable

 

Factor investing is not as easy as some may state. Factor returns are variable, do not show consistent Sharpe ratios, and are subject to drawdowns. They are driven by different rationales and different trading groups. Factors will also behave differently across the business cycle and different economic environments. 

While there have been hundreds of studies of factors, it still seems to be the case that there are a set of core factors that show persistence; nevertheless, these factors can still fall in and out of favor based in the changing market environment. Investing in factors is risky as seen by the wide variation in Sharpe ratios across asset classes and through time. Drawdowns for even factors that show strong persistence can be very deep (beyond 20%). Factor investing provides diversification benefits, yet factor returns will be lower when there is an overall market decline.

See "Fact, Fiction, and Factor Investing".

Our core view is that factor investing should be integrated with price trend and global macro investing. Follow trends in factors given the return dispersion through time. Follow the key macro factors given the sensitivity of factors to macro trends. Exploit the time series, exploit the behavior across macro regimes, and use the rich/cheapness of factors to gain an edge. There is no guarantee of excess returns, but the strong cyclical behavior suggests that avoiding periods of factor underperformance will be helpful for any factor investor.