What if the very qualities that make factor investing so compelling are ultimately responsible for driving “smart beta” premia to extinction?

Figure 1: New investment concepts follow the technology adoption life cycle

Source: Smith House. For illustrative purposes only.

Over the last few years investors have been clamoring for so-called factor, or smart-beta strategies. These strategies emerged from academia, predicated on the work of Treynor, Sharpe, Haugen, Fama, French, and others in the late 1980s and early 1990s. Many early hedge-funds earned extraordinary profits from these strategies in the 70s, 80s and 90s by allocating to stocks with strong momentum or deep value characteristics, or markets with strong trends. 

In some ways new investment concepts are like any new technology. The progenitors of any early technology typically earn extraordinary profits until competition heats up. Eventually competition drives down profit margins and the technology becomes commoditized. 

But investment technology has a special quality that arises from the adaptive nature of markets. This property means that the profitability of investment concepts conforms to a unique trajectory, which most investors haven’t accounted for.

Figure 2: Trajectory of new investment concepts

Source: ReSolve Asset Management. For illustrative purposes only.

Factor investing is predicated on the idea that an investment opportunity exists because securities with certain characteristics are systematically mispriced by a cohort of investors. This may be because these investors are influenced by unique preferences or perceptions of risk. 

Smart beta / factor strategies typically derive their credibility from academic credentials and peer reviewed journals. A paper is published which describes an investment strategy with an intuitive origin story. A backtest and comprehensive analysis is presented with strong economic and statistical significance. 

Word spreads about the new investment concept. A few big institutions jump on board. Innovative managers launch funds, which do well for a few years and catch the eye of more adventurous investors and advisors. A few more years pass. Now most institutions are running the strategy internally. Index providers have launched a mosaic of takes on the concept, many of which go on to inform new index ETFs. 

There comes a point when the arbitrage dollars start to crowd out the investors who were creating the opportunity in the first place. The securities that were under-priced become over-priced. The sign of the edge inverts – it is now a money-losing investment!

What do you think happens next? Investors eventually cry uncle and abandon the strategy in droves. At some point, the market finds a new equilibrium premium that is just large enough to keep the most disciplined investors engaged, but much smaller than the original pre-publication premium.

Figure 3: Mass adoption in action Imminent abandonment?

Source: AQR. For illustrative purposes only.

How about a concrete example to help to crystallize the concept? 

Many of you will recall that a few of the most sophisticated institutions and hedge funds started running systematic alternative premia strategies in the mid-2000s to harvest the size, value, low volatility, trend, momentum, carry and other so-called “factor” strategies.

These innovators and early adopters harvested rich premia for a few years before the ideas went mainstream. 

By 2011-2012 the investment banks had launched alt premia indices and major investment managers launched funds, attracting tens of billions of arbitrage capital from the Early Majority investors. These billions were typically levered up 5x-10x. 

By 2015 most major institutions had built or were building internal desks to harvest these premia and eliminate fund fees and retail investors were getting in on the action via an array of index funds. 

Fast forward to 2016-2017. Alt premia strategies were broadly adopted and many of the largest Style Premia funds started to close to new investors. The Late Majority was “all-in”. Peak Alt Premia. What happened after 2017?

INVERSION

This chart plots the cumulative alpha from a benchmark combination of leading alternative premia and systematic multi-strategy funds from January 2018 through July 2020. We scaled the funds to express equal risk in the portfolio and called it the Alt Premia Benchmark.

Figure 4: Cumulative alpha of Alt Premia Benchmark*

Source: Data from Bloomberg. Analysis by ReSolve Asset Management. *Chart represents cumulative alpha of an Alt Premia Benchmark that combines an alternative risk premia fund and a systematic multi-strategy fund weighted for equal volatility. Check disclaimer for constituents.

We also overlayed a cone that charts the trajectory of a random walk with zero return and the same volatility as the Benchmark. Over the past 30+ months this composite – representing over fifteen different alternative premia sleeves – has produced a return trajectory that falls well below the lower threshold of the cone. 

We’re reminded of a colorful anecdote from Nassim Taleb’s book, “The Black Swan” starring the characters Dr. Bob and Fat Tony. A third party asks them to assume that a coin is fair, i.e., has an equal probability of coming up heads or tails when flipped. I flip it ninety-nine times and get heads each time. What are the odds of my getting tails on my next throw? 

Dr. John is dogmatic in his belief that the rules from a theoretical model of dice throwing must apply. He says that the odds are not affected by the previous outcomes so the odds must still be 50:50. 

Fat Tony says that the odds of the coin coming up heads 99 times in a row are so low that the initial assumption that the coin is fair must be false. He figures, “The coin’s gotta be loaded!” 

The chart above implies less than 1 chance in 1000 that the returns from our alt premia benchmark are drawn from a distribution with a positive mean. Dr. John says this is just an unfortunate coincidence. Fat Tony can’t help but conclude that something fundamental has changed. 

So guess what – our conversations with institutions and consultants makes clear that investors are heading for the exits. Pension and endowment funds are dismantling factor desks and major wire-houses have started de-listing associated funds. 

It’s ok – these premia were legitimate and the market will eventually find an equilibrium that compensates arbitrage investors for taking on unwanted risk from other classes of investors. The premium will be lower – probably on par with other major premia like the equity risk premium or the duration premium. But commoditization will drive costs down commensurate with lower long-term returns.

The signals that we have been trading without interruption for

fifteen years make no sense.

Otherwise someone else would have found them.

Robert Mercer – former co-CEO of

Renaissance Technologies

So what’s the lesson?

Investors seek comfort in economic intuition, expert opinions, peer reviewed academia, and recent performance. Sadly, these are the very qualities that destroy future returns. Alpha lives in the crevices and dark corners; lonely places where most investors don’t want to go. 

If asset owners and investors want to earn excess returns then by definition, they must come to grips with the reflexive nature of markets. Where a strategy offers comfort in the form of published research and peer adoption, with simple mechanics, compelling backtests and intuitive stories, we should expect the market to quickly mediate this opportunity. There is no free lunch!

Figure 5: From naïve factors to bespoke factors

Source: ReSolve Asset Management. For illustrative purposes only.

So what works? 

At ReSolve we are reformed factor investors. Where factors typically have intuitive explanations rooted in economic theory, we source edges directly from the empirical data. Where factors are predicated on common relationships across all assets, we seek patterns in the data that are unique to each market. Where factor relationships are simple in structure, we seek complex relationships that are difficult to spot. Where factor strategies rely on long-term average investor behaviour, we evaluate how markets respond under different conditions. And perhaps most importantly, where factor strategies are evaluated on typical in-sample backtesting methods, our strategies are validated by the advanced out-of-sample and hold-out methods used in machine learning.

Most importantly, investors must recognize that in adaptive markets the only sustainable edge is constant innovation. That means constantly seeking information sources that explain market returns from different angles. This involves many of the same features that factor investors use, as well as new data points sourced from, for example, the volatility surface, dealer gamma, dark index flows, cross-market information, and other alternative data sources.

But new information sources alone don’t produce alpha. You must have the infrastructure to constantly mine-for and select the best new strategies, weed-out antiquated edges, and pipe the constantly adapting alpha engine through to production.

While these concepts may be intuitive to some investors, we realize they can sound controversial and even uncomfortable to many. We have been debating these ideas internally for some time, and decided it was time to share our thinking. This is hopefully the start of a conversation that we intend to have with our clients, peers and the broader investment community. To that end, we have recently released a podcast on this theme, Resolve Riffs on a Post Factor World, (click here to watch or listen.) We certainly welcome your feedback.

If you have any questions, don’t hesitate to contact us.

DISCLAIMER

Confidential and proprietary information. The contents hereof may not be reproduced or disseminated without the express written permission of ReSolve Asset Management Inc. (“ReSolve”). These materials do not purport to be exhaustive and although the particulars contained herein were obtained from sources ReSolve believes are reliable, ReSolve does not guarantee their accuracy or completeness.

The material has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such.

This information is not intended to and does not relate specifically to any investment strategy or product that ReSolve offers. It is being provided merely to provide a framework to assist in the implementation of an investor’s own analysis and an investor’s own view on the topic discussed herein. The investment strategy and themes discussed herein may be unsuitable for investors depending on their specific investment objectives and financial situation.

ReSolve is registered as an Investment Fund Manager in Ontario, Quebec and Newfoundland and Labrador, and as a Portfolio Manager and Exempt Market Dealer in Ontario, Alberta, British Columbia and Newfoundland and Labrador. ReSolve is also registered as a Commodity Trading Manager in Ontario and Derivatives Portfolio Manager in Quebec. Additionally, ReSolve is a Registered Investment Adviser with the SEC. ReSolve is also registered with the Commodity Futures Trading Commission as a Commodity Trading Advisor and a Commodity Pool Operator. This registration is administered through the National Futures Association (“NFA”). Certain of ReSolve’s employees are registered with the NFA as Principals and/or Associated Persons of ReSolve if necessary or appropriate to perform their responsibilities. ReSolve has claimed an exemption under CFTC Rule 4.7 which exempts ReSolve from certain part 4 requirements with respect to offerings to qualified eligible persons in the U.S.

PAST PERFORMANCE IS NOT NECESSARILY INDICATIVE OF FUTURE RESULTS

Any fund units will be issued under exemptions from the prospectus requirements of applicable securities laws and will be subject to certain resale restrictions. Neither the Ontario Securities Commission nor any other securities regulatory authority of any jurisdiction has passed upon the accuracy or adequacy of this presentation, and any representation to the contrary is unlawful.  This presentation does not constitute an offer to sell or a solicitation of interest to purchase any securities or investment advisory services in any jurisdiction in which such offer or solicitation is not authorized.

Forward-Looking Information. This presentation may contain forward-looking information. Because such forward-looking information involves risks and uncertainties, actual results of the funds or accounts may differ materially from any expectations, projections or predictions made or implied in such forward-looking information. Prospective investors are therefore cautioned not to place undue reliance on such forward-looking statements. In addition, in considering any prior performance information contained in this presentation, prospective investors should bear in mind that past results are not necessarily indicative of future results, and there can be no assurance that the funds or any account will achieve results comparable to those discussed in this presentation. This presentation speaks as of the date hereof and neither ReSolve nor any affiliate or representative thereof assumes any obligation to provide any recipient of this presentation with subsequent revisions or updates to any historical or forward-looking information contained in this presentation to reflect the occurrence of events and/or changes in circumstances after the date hereof.

General information regarding hypothetical performance and simulated results. Past results are not necessarily indicative of future results. It is expected that the simulated performance will periodically change as a function of both refinements to our simulation methodology and the underlying market data. These results are based on simulated or hypothetical performance results that have certain inherent limitations. Unlike the results in an actual performance record, these results do not represent actual trading. Also, because these trades have not actually been executed, these results may have under- or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated or hypothetical trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account or fund will or is likely to achieve profits or losses similar to those being shown. The results do not include other costs of managing a portfolio (such as custodial fees, legal, auditing, administrative or other professional fees). The information in this presentation has not been reviewed or audited by an independent accountant or other independent testing firm. More detailed information regarding the manner in which the charts were calculated is available on request. Any actual fund or account that ReSolve manages will invest in different economic conditions, during periods with different volatility and in different securities than those incorporated in the hypothetical performance charts shown. There is no representation that any fund or account will perform as the hypothetical or other performance charts indicate.

General information regarding the use of benchmarks. The Alt Premia Benchmark consists of an equal volatility weighted combination of the following U.S. mutual funds: AQR Alt Style Premia Fund (QSPIX), AQR Multi-Strategy Alternative Fund (ASAIX) scaled to 10% annualized volatility. The constituents in the “Multi-factor to Bespoke Factors (January 1990 – August 2020) SIMULATED PERFORMANCE” are described in Appendix A: Investment Universe.