Transcript: Does factor investing still work?

This is an audio transcript of the Unhedged podcast episode: ‘Does factor investing still work?’

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Ethan Wu
We’ve discussed on the show the duel between active and passive investing — active, where you’re taking a view on the market; passive, where you’re just accepting what the market delivers to you. But what if I told you that you could have the best parts of passive and the best parts of active all in one investing strategy? Too good to be true? Today on the show: factor investing.

This is Unhedged, the markets and finance show from the Financial Times and Pushkin. I am reporter Ethan Wu here in the New York studio, joined from London by markets columnist Katie Martin, the scourge of the factor investing world, I think it’s fair to say.

Katie Martin
I don’t know about that, Ethan Wu. It’s a bit much.

Ethan Wu
We’ll see. Listeners, you can decide if Katie is really the scourge of factor investing because Katie has just written a quite sceptical column about the investing strategy, which we’ll get into in a minute, around the very same time that Rob Armstrong and I travelled to Greenwich, Connecticut; took the train up from New York City from Grand Central station and went to visit the offices of Cliff Asness of AQR, one of the biggest, most important quantitative hedge funds and factor investing hedge funds, to have a kind of wide-ranging discussion about factor of investing value, all kinds of stuff. You can read about it in the Unhedged newsletter, but we thought it would be a good time to talk about, you know, what’s the case for factor investing and why Katie doesn’t buy it. But before we get there, Katie, we need to start with what the hell is factor investing? And I’m throwing it to you first because I do not know how to explain it.

Katie Martin
I think the simplest way to think about it is that you can invest just based on what you call beta. So when I say a beta here, like this is a reference to the Greek letters, right? So alpha is the amount of special return that you can make as an investor layered on the top of your beta which is — or beta if you want to sound, you know, even cleverer — which is the kind of basic return that comes out of the market based on a big index like the S&P 500. This is something that’s in between that. It picks out individual stocks and bunches them together in different ways. And so you have something that people have called “smart beta” — smart beta; you know, you can choose which one you prefer — that is a kind of a cleverer way of tracking a large number of stocks in a kind of mathematical way but that is not quite stockpicking where you are saying, I think this retailer, this oil company and this tech company are going to beat the rest of its peers.

Ethan Wu
Yes. Thank you for translating not just from Greek, but also to American from British.

Katie Martin
So, for example, you can say, I just want to buy momentum stocks — stocks that have got a provable track record recently of moving higher. So I only want to chase the winners because I think that those winning patterns can sustain themselves. Or you can say, I think small caps — you know, small companies, small capitalisation companies — have superior qualities to large companies. So I want to buy small caps. Or you can say, I want to buy stocks that are attached to large dividend payments. I wanna buy income stocks. Or you can do what is probably the most popular of them all and say, I want to own value stocks. So not the whizz-bang kind of fast-growing companies that currently dominate the US market in particular, but kind of beaten-up, unloved value stocks that are kind of cheap relative to or that you can argue are cheap relative to the quality of the business.

Ethan Wu
You know, that’s exactly right. There’s all these different nuances. But the key thing is that you’re trying to get at these fundamental attributes. And I think it’s all based on the idea that there’s some kind of behavioural quirks in markets that are built in, right? Take momentum, for example, Katie, like you mentioned. So stocks that go up tend to keep going up in general, at least for some amount of time. Why would that be? Well, maybe it’s because, you know, I see, the line go up, I see the line turn green on my screen and I say, well, that’s exciting. I’m gonna buy into that. And if just enough people out there have that kind of behavioural quirk, right, where they’re more likely to buy stuff that goes up, that’s a bias that investors have, that someone, a factor investor on the other side can exploit, can take advantage of. And there’s a theory for kind of all of them, right? So for value it’s, yeah, the beat-up stocks are slept on. People forget about them and they don’t care. Or you know, quality — people systematically underrate companies that have good balance sheets. And you can, you know, you can make different arguments for all of them. But that’s sort of the basic idea, right, that there are structural behavioural characteristics of markets that are baked in at a deep level that’s hard to see if you’re just buying, you know, I’m gonna buy a financials ETF or I’m gonna buy, you know, the Russell 2000 small-cap index, those are too broad. You need to get more specific and more narrow to get that real signal.

Katie Martin
So like all of this comes like not from trading floors, right? It comes from academia.

Ethan Wu
Yeah, that’s exactly right. You know, I think that’s what lends like an era of, like, mystique and quantitative sexiness to this whole enterprise. But, you know, sort of the foundational work here that, you know, some listeners who have maybe taken a finance class will know about is the so-called Fama-French three-factor model. This is from a paper written by two, I believe it’s University of Chicago professors in 1992, and they on top of the normal market beta that we’ve already talked about, they use the kind of two canonical factors: size and value. So small companies beat large companies; cheap companies — you know, the price relative to the assets — beat more expensive companies. And they looked at 29 years of data from 1963 to 1991 to do their analysis. And it’s been obviously updated many, many times. And there are all these databases that stretch across financial history.

But this was kind of the foundational work in the early ’90s that sort of birthed factor investing in general, and it’s been expanded, led to this whole factor zoo, just every factor you could possibly imagine. And Fama-French themselves have contributed to that, that they later expanded the three-factor model to the five-factor model after a whole bunch of academic debate. But that sort of points to the origins with two very simple stories, right, that small companies are going to be underestimated and cheap companies are going to be underestimated.

Katie Martin
Exactly. It’s this idea that, you know, just looking at a big index only gives you one way of looking at the world. And it’s actually really important to remember if you do look at one big index like say, S&P 500, which is what we always come back to. It’s quite a complex thing and it’s market-weighted. And it pushes investors almost without them realising it into large companies that are all based in one country. And so there is no such thing as a neutral benchmark. And so what smart beta does, what all these different kind of factors are doing is saying there are different ways to look at the universe of stocks that is out there rather than just being pushed into this market capitalisation-weighted S&P 500.

Ethan Wu
And Cliff asked us himself, actually studied under the aforementioned Fama of the Fama-French model at the University of Chicago. So he’s kind of part of this lineage of academics who then go into quantitative investing.

Katie Martin
The problem is with this is that if you look at how these factors perform over time, the factors definitely exist and the things that bind these stocks together definitely exist. But over quite a lot of different time periods, they just don’t perform terribly well.

Ethan Wu
Say more about that.

Katie Martin
So for example, I think I might have mentioned before the investment returns yearbook that UBS puts out. It’s a huge, huge document . . . 

Ethan Wu
Total doorstopper. But it’s amazing.

Katie Martin
. . that comes out every year. It is a doorstopper, yeah. It sort of carves up data going back as far as it can for each. So as each factor has been identified in the kind of academic publications over the previous decades, it looks at how they’ve performed over time.

The problems are so if you look in the short term, factor investing was just a nightmare last year, particularly in the States. So all of those big factors underperformed, effectively. Nothing really worked out.

But at the same time, some of the factors, particularly momentum, for example, did work in the UK. And so one of the problems with factor investing is picking out, OK, this factor works in this country at this time. Why doesn’t it work globally at one period in time? Why does it differ from one country to another, and why does it work some years and not in others?

And that is the problem that this yearbook has identified, is that if you look back particularly last year, but also over recent decades, some of these factors simply don’t perform very well. You’re much better off just sticking your money in an index and leaving it there. And value investing in particular has just demonstrated really poor . . . So it’s demonstrated what they call negative premiums. So if you look at how value has performed relative to whizz-bang growth stocks, it’s generated negative premiums for like 37 consecutive years in the States. So it’s just not working out terribly well. But I know that, for example, this whole style of investing has some really loud and heavyweight supporters, right?

Ethan Wu
Well, this is sort of the issue with quantitative investing, right? You end up in a shouting match of two equally smart, angry people who would like to argue about the methodology and say, you measured it wrong. And it’s actually good if you measure it differently or it’s bad if you measure it differently. So that’s the problem with a lot of the stuff, but . . . So I mean, you know, we put this question to Cliff Asness of AQR: you know, why has value stunk up the room in recent decades and just been made up perhaps a little bit less than glamorous in the long run?

And, you know, his argument is these things move in long-term regimes that value, when compared to growth, will do quite poorly for a long time and then will do very, very well. And he sort of analogised it to something else that we’ve talked about in a different domain on the show, which is how much US stocks have beat global markets in recent decades. So we’ve had 10 or 15 years of the US absolutely crushing Europe, crushing Japan, crushing emerging markets. But in the decades prior to that, the narrative was completely inverted. It was that, why would you wanna buy the US, right? So it’s all, you know, it’s all the risks and for less reward. And you wanted to be in EMs, you wanted to be in . . . Oh, I don’t know about European stocks but maybe global stocks, more generally.

And Cliff’s point is, notice how much and how drastically those narratives can change. It’s kind of the same story in value versus growth — that you have long-term outperformance of growth, which is what we’ve had recently. You might expect that to flip, as it has in the past. He points to his own funds, you know, better performance with value recently. And they’ve taken various ways to try to augment it. But that’s basically the argument, right, that if you believe value investing has some root in human nature, right, in the fact that we overlook fuddy-duddy stocks that have lost their sheen, that’s not going away. It just might take time for it to show up in your numbers. And you have to be patient.

Katie Martin
Yeah. The counterpoint to that is that some stocks are cheap and therefore represent value for a reason, and they’re gonna stay there. So, you know, an email that I received the other day on the back of the column that I did a few days ago saying that value investing is and I quote from email, “a boring, miserable, lonely enterprise undertaken by a handful of weirdos buying cast-off cigar butts”. So it is kind of odd how this kind of level of number-crunching and attempts to beat the market can get people quite so hot under the collar. But I guess that’s quant for you.

Ethan Wu
Well, I mean, on the other hand, you were telling me that SocGen’s out here saying that we’re having a “quant-tastic” 2024 isn’t that right?

Katie Martin
Start to the year, certainly. They were saying it’s been quant-tastic. So, you know, put that in your pipe and smoke it. But I think, you know, the overall message here is that, first of all, certain efforts to understand the universe of stocks work really, really well on paper, and you can backtest it through decades and decades of market behaviour. But when you actually try and implement it, then it can be, it’s just ephemeral. It just sort of disappears, it gets arbitraged away or it becomes too popular and just stops working. And so there are lots of things that work on paper and work in academic papers that just don’t work terribly well in real life.

The other is that, you know, I’m afraid there’s just too much that happens in stock markets that is, frankly, the function of chance and just like dumb luck. And if you think that you can mathematise and systematise the, you know, all of the stocks that are out there in a way that will guarantee that you’re going to beat the market, then you’re probably going to be disappointed certainly over the short term. If you can afford to like hang on for decades and decades, then yes, you know, some of these things do generate decent numbers. But in the sorts of timeframes that most people are investing for, you know, maybe five, 10 years at a time, you might find yourself extremely disappointed. So I’m afraid there’s just no way to — I mean, people will disagree with me and that’s fine. You know, I’m a grown-up — but there’s no certainly no easy way to come up with a formula that is a trick for breaking the market and for beating the market. It doesn’t matter how clever an academic paper you’ve got to hand. It’s just tough out there.

Ethan Wu
And those are both great points. And maybe I would add a third one, which is if you’re doing smart beta, the smart part is kind of the operative word, which means it really matters who’s running your money. They have to be really smart. They have to be not only smart but actually smarter than the other guys doing smart beta, right? If you’re gonna outperform your manager selection is incredibly, incredibly important, which is what makes it hard to . . . You know, I’m not surprised that the UBS yearbook shows lacklustre returns from factor investing because it’s, you know, they’re taking the average performance, and, you know, the average person doing a smart strategy may or may not actually be smart.

Katie Martin
Yeah. So if you, you know, if you’re kind of casting through the internet and you read something somewhere that says, you know, we’ve got a formula that can beat the market, I guess the moral of the story is: be sceptical.

Ethan Wu
Well, Katie, when you find a magic formula, do let me know.

Katie Martin
No way. If I find a magic formula I’m keeping it all to myself.

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Ethan Wu
You’re keeping it to yourself.

Katie Martin
I’m not putting it in any papers. Oh, no. It’s all mine.

Ethan Wu
I can’t blame you there. We’ll be back in a moment with Long/Short.

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Welcome back. This is Long/Short, that part of the show where we go long a thing we love, short a thing we hate. Katie, I am long Big Tech AI spending, which is absolutely off the charts. I was like blown away by this number that was in a recent Bank of America research report. These four companies — Microsoft, Amazon, Google and Meta — in 2024 are expected by analysts to spend a combined $180bn on capital expenditure, a 27 per cent increase from 2023. It’s just a staggering number.

Katie Martin
That is a chunk of change.

Ethan Wu
Yeah. That’s like a small country, right, that they could buy out. And I think it feeds kind of into this broader idea that there’s a bit of a revival in risk sentiment. People are feeling pretty confident about the AI story. You’re about as confident as you can for an emerging technology. And there’s real money going into it. I mean, it’s just really striking. So I am long Big Tech AI spending.

Katie Martin
You’re long animal spirits. This is basically what you’re long. 

Ethan Wu
I guess that’s right.

Katie Martin
So I’m gonna be short gold because the market is very long gold and doesn’t know why. So gold has gone bananas. It’s added like 77 per cent in its price in a week. It’s like the price tickled $2,200 a troy ounce recently. It nearly got to that kind of big level. The funny thing about it is — and there’s quite a lot of coverage on the FT website about this — is the, you know, our reporters have diligently gone out there and spoken to all the kind of gold analysts that they always talk to and say, hey, what’s going on with the gold price here? And you know what they’re saying? They’re saying: I don’t understand this. So I don’t know what is going on. So you could say, you know, gold is up because it’s doing its thing, right? It kind of, it’s rising on geopolitical risk or, you know, it’s rising on the idea that the Federal Reserve’s gonna cut interest rates because you feel kind of better owning a pet rock that doesn’t pay you any dividends or interest. But the thing is, none of these factors are like new. So it’s a bit difficult to say that like geopolitics is like 7 per cent worse since the start of March, whereas, you know, the gold price is 7 per cent higher. So none of the normal explanations for the catalyst for this latest run higher really work. That’s telling me that this feels a little bit unsustainable to me.

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Ethan Wu
Yeah. All right, Katie, thanks for being here. We’ll have you back soon. And listeners, we’re back in your feed on Thursday with another episode of Unhedged. We’ll catch you then.

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Unhedged is produced by Jake Harper and edited by Bryant Urstadt. Our executive producer is Jacob Goldstein. We had additional help from Topher Forhecz. Cheryl Brumley is the FT’s global head of audio. Special thanks to Laura Clarke, Alastair Mackie, Gretta Cohn and Natalie Sadler. FT premium subscribers can get the Unhedged newsletter for free. A 30-day free trial is available to everyone else. Just go to ft.com/unhedgedoffer. I’m Ethan Wu. Thanks for listening.

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