Mike Hunstad is worried that factor investing is getting a bad rap. Hunstad, head of quantitative solutions at Northern Trust Asset Management, says his big concern is when the industry looks at factor strategy underperformance and assumes factors themselves haven’t performed, “when that isn’t the case,” he told ThinkAdvisor.
Instead, factors have performed just fine. “There’s a growing belief that factors in the U.S. have not performed well, when really it’s the strategies that are poorly designed,” he says.
To prove his point, Hunstad authored a new paper, “Danger!! Dilution is Harmful or Fatal to Multi-Factor Performance,” in which he outlines his contention that many multi-factor funds are diluting factor exposure to the detriment of returns.
“Year to date there’s been a lot of volatility in the equity market, and we would expect defensive strategies, for example, low-vol strategies, high-quality strategies, to have outperformed but most have not,” he said. “So the general perception is that low-vol factors have underperformed, but that is not the case.”
A big part of factor strategy return is “predicated on how [the portfolio is] designed … so anytime you implement a factor in a portfolio, you tend to take extra risk that is not necessarily based on that factor exposure.” Hunstad notes that low-vol stocks tend to be concentrated in certain sectors, such as utilities, real estate and consumer staples, all of which have “a lot of idiosyncratic risk associated with them, tend to be larger in size, tend to be expensive, have large-cap bias and a negative value bias,” he says. “So you think you’re getting low vol, but what you’re actually getting is big bets on” those sectors and their risks.
Hunstad points out that in 2018 the low-volatility factor has outperformed the benchmark, but low-vol strategies have underperformed. The reason, he says, is these strategies are overweighted in sectors like utilities and real estate that “have gotten crushed” this year.
Factors Lost That Loving Feeling?
Despite underperformance of sector strategies, factor investing is still hot. According to Hunstad’s paper, as of 2018, $1 trillion in assets were invested in factor-based equity funds — a whopping 30% growth over the previous year. Further, there are thousands of factor products now available.