AQR’s Asness Assesses Impact of Factor Crowding

AQR Asness Assesses Impact of Factor CrowdingFactor based investment strategies (those based on a specific factor, or multiple factors, such as value, quality, momentum, etc.) are at the core of what is now known as smart beta. And while active managers have always built portfolios with active factor tilts (knowingly and unknowingly), it has really been the emergence of quantitative investing, combined with the development of exchange traded funds (ETFs), that has catapulted this investment approach to the forefront of the industry today.

So now that factor-based investment strategies have been discovered, and are widely available, the question becomes, “Will they continue to work?” That’s the question tackled by AQR’s Cliff Asness in his engaging Cliff’s Perspective white paper from August 31: “How Can a Strategy Work if Everyone Knows About It?

The Asness Assessment

Factor-based strategies have steadily been gaining popularity over the past 20 years, and this has led many investors to worry that the risk premia generated by the strategies may be “arbitraged” away. Mr. Asness thinks such fears are overblown.

While “alpha,” by his definition, must be based on insights that are relatively unknown, smart beta occupies a sort of middle ground between beta and alpha. Of course it would be better to be the only person with insights into a particular strategy, but this is impractical. Given a choice between what he calls “classic factors,” Santa Clause, the Eastern Bunny, and a “truly unique alpha that you can identify ex ante and invest in at a high but fair fee,” he says classic factors are the best bet since they are the only choice that actually exists.

Why Do Factor Strategies Work?

Mr. Asness identifies two reasons that factor strategies work:

  1. Compensation for risk
  2. Investor error

In the case of the first, there’s no way the strategies’ outperformance can be “arbitraged away,” since compensation is always required for risk. The example he uses is the value strategy, wherein supposedly “cheap” stocks are identified and bought. These stocks tend to make small gains over time as compensation for the risk of holding them. The risk, Mr. Asness says, is that value stocks are susceptible to shocks during times of market stress.

“Investor error” refers to times of what Alan Greenspan famously dubbed “irrational exuberance.” Mr. Asness uses the late-90’s tech bubble as an example of a time when value stocks significantly lagged growth stocks. Obviously, this was irrational, in retrospect. Below is an image depicting the “value spread” of U.S. stocks. The red line is the historical median.

Value Spread of US Stocks

If factor strategies truly compensate for legitimate risk, then they can’t be arbitraged. And if they’re based on investor error, why would they ever go away?

Growing Popularity

It is true, however, that a strategy’s popularity brings with it its own risks. Once a strategy is discovered, investors crowding into the strategy will eat away at the strategy’s ability to outperform, all other things being equal – but for investors already invested in the strategy, this will have a positive effect. Of course, once many investors are piled into a strategy, then the well-known strategy faces the risk of negative flows. This is one of the many reasons Mr. Asness concedes that the fewer people who know a strategy the better, with the optimal number of practitioners being one (yourself).

But is there actual evidence that factor strategies are no longer performing? Mr. Asness doesn’t think so. He points to the value spread’s current level near its historical median as evidence the value strategy isn’t overbought. If it were, then one would expect the value spread to be below the median level.

Advice to Investors

Mr. Asness closes his white paper with a list of seven tips for investors. Among them:

  1. Assume attractive but lower-than-historical rewards for popular strategies;
  2. Outflows present added risk for popular strategies, but these concerns are mostly short-term in nature;
  3. Despite their growing popularity and the risks that come with it, factoring strategies should be added to portfolios that lack them;
  4. Investors should allocate to factors and stick to them;
  5. Look to the “classic strategies” that are the least crowded;
  6. Long/short is preferable to long-only, where applicable; and
  7. Don’t pay alpha-like fees for strategies that are well known.

For more information, download a pdf copy of the white paper.

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