Some Thoughts on the Struggles of Factor Investing in the Past Decade

Episode Summary

Executive Summary: The episode examines the weak decade-long performance of factor investing, especially value and momentum, and argues it is too early to declare them broken. The hosts stress that factors can underperform for long stretches, that short bursts of outperformance matter, and that investors should choose a factor approach they can actually stick with through painful cycles.

Main Topics: Decade-long struggles of value and momentum (Priority: 5/5): The discussion opens with how the two most supported factors in academic research—value and momentum—posted negative excess returns over the past decade, raising doubts among investors. Why it is too early to abandon factors (Priority: 5/5): The speakers argue that a decade is not enough to conclude a factor no longer works, and cite research suggesting the evidence horizon needed is longer than a typical investor lifespan. Patience, cycles, and regime dependence (Priority: 4/5): They explain that factor returns are cyclical and often depend on macro conditions such as recessions, inflation, and interest rates, which have been unusually stable since the financial crisis. Value’s concentration of returns in short bursts (Priority: 4/5): The conversation highlights that much of value’s long-term return historically came in very brief windows, meaning investors can miss the payoff if they abandon the strategy too soon. Choosing the right implementation style (Priority: 5/5): They compare concentrated deep-value portfolios with more diversified or reweighted factor approaches, emphasizing that the best strategy is the one investors can tolerate. Outlook for the next decade (Priority: 4/5): The hosts remain constructive on factors, especially value and momentum, believing recent underperformance may prove anomalous rather than evidence of permanent failure.

Key Arguments: Value and momentum, despite strong academic backing, had negative excess returns over the past decade, making the period unusually difficult for factor investors. A decade of poor performance is not sufficient evidence to conclude a factor is dead; the statistical horizon required to prove that may exceed an investor’s lifetime. Factor investing is as much about judgment and behavioral endurance as it is about data, because the data alone may never provide a clean cutoff for abandonment. Value may have struggled partly because the post-crisis environment featured falling rates, falling inflation, and few recessions—conditions that historically have been less favorable for value. A large share of value’s long-run outperformance can come in short, concentrated bursts, so investors who exit during drawdowns may miss the rebound. Investors should prefer factor implementations they can actually hold through long periods of underperformance; a diversified tilt is often more practical than a concentrated deep-value portfolio. Despite recent pain, the long-term evidence base still supports factor investing, and past periods of weakness have often been followed by strong future results.

Data Points: Long-term factor leaders: Value and momentum - Identified as the two factors with the strongest historical excess-return evidence over the long run. Recent performance horizon: Past decade - The primary period discussed, during which value and momentum both had negative excess returns. Excess return for value: Negative - Buying the cheapest stocks and shorting the most expensive stocks would have lost money over the decade. Excess return for momentum: Negative - Buying the highest-momentum stocks and shorting the lowest-momentum stocks also produced a negative return over the decade. Positive factor premium: Quality - Mentioned as one factor that still had a positive premium over the decade. Best-performing factor in decade: Low volatility - Described as having the most significant positive premium in the last decade. Time to reject a factor statistically: Longer than most investors’ lifetimes - Citing Corey Hofstein/Newfound Research, the discussion argues that pure data cannot easily prove a factor is permanently dead. Suggested commitment period: 20 years - The speaker says an investor should probably be willing to endure about 20 years of underperformance before allocating significantly to a factor strategy. Example lookback period: 20 years - Used to illustrate that a factor can appear mediocre over a full period while most of its gains came in only a few years. Value outperformance window: 2000 to 2003 - Cited as the period when value captured most of its gains after the dot-com bubble burst.

Pivotal Quotes: "both of those had negative excess returns" — Jack: Summarizing the decade-long performance of value and momentum. "the amount of time it would take to say for sure that they don't work anymore is longer than most investors' lifetimes" — Jack: Explaining why it is extremely hard to prove a factor has permanently stopped working. "you probably should not be getting involved in one of these factor-based value strategies... unless you're willing to sit through 20 years if it doesn't work" — Jack: Describing the patience required to hold a factor strategy through prolonged drawdowns.

Implications: Investors should not abandon factors based on one weak decade. The episode argues for long horizons, realistic expectations, and factor implementations sized to survive long stretches of underperformance.