by Corey Hoffstein, Newfound Research

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  • 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.

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