by Corey Hoffstein, Newfound Research

This post is available as a PDF download here.

  • Research Affiliates published a new piece of research exploring mutual fund returns over the last 25 years and the implied ability for managers to capture popular factor premiums published by the academic community.
  • They argue that several factors accepted in academia may not be implementable after real life frictions (e.g. transaction costs, cost of shorting, missed trades, et cetera).
  • Their research finds significant shortfall between published factor premiums and realized factor premiums.
  • We believe that a sufficient proportion of the shortfall can be explained by estimation error in their process and, therefore, we should refrain from drawing conclusive results until more evidence is published.
  • As a larger point, we acknowledge the inherent biases people exhibit to defer to authority and accept as truth the things they read outside of their own areas of expertise.
  • Financial research is, in many ways, like a backtest: it is rarely published unless it is interesting and supports the firm’s existing products or viewpoint. It should, therefore, be met with much the same skepticism.

Research Affiliates published a new piece this week titled The Incredible Shrinking Factor Return (Unabridged) (henceforth AKW for the authors’ last names: Arnott, Kalesnik, and Wu).[1]  A rather hefty and wonkish read, the ultimate conclusion they draw is that factor returns actually realized by investment managers are far below those purported to be available by long/short factor research.

While they do not provide evidence as to why the shortfall exists, they do put forth several potential reasons, including:

  • The long/short portfolios ignore trading and transaction costs.
  • The true cost of shorting may be prohibitively high.
  • Trades may be missed (e.g. shorts may not be available).
  • Fund fees may significantly erode captured alpha.

The huge disparity between realized and theoretical factor returns put forth in this piece draws into question the entire benefit of factor-based investing, particularly for high-turnover factors like momentum which may incur the brunt of the implementation cost.

Finding new ways to question broadly accepted beliefs is a laudable pursuit.  We believe, however, that there is reason to remain skeptical about these particular results.

Understanding the Research Affiliates Method

AKW employ a “two-stage” regression approach.

First, using fund data from the Morningstar Direct Mutual Fund Database, they compute monthly returns from January 1991 to December 2016.  For each fund, they regress the monthly returns against four factors: Market, Value, Size, and Momentum.  This regression process identifies how much exposure the fund has had to that factor over time.

This is a fairly standard way of creating a “factor lens” through which to identify where fund performance is derived.

The second stage of the process can be a bit confusing if you’ve never come across it before.

Each month, they take the actual fund returns and regress them against the factor betas they just calculated in the prior step.  The result is estimated returns for each factor for that month.  Or, more strictly, estimated returns for the factor as captured by the funds.

For each factor, the long-term average of these estimated monthly returns is compared to the long-term average of the true factor performance.  The difference between the two long-term averages is the “implementation shortfall.”

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