The EconomistJuly 20th 2019 Finance & economics 632
Buttonwood The factor fear
T
he finalof the European Football
Championship in 1976 was settled by
a penalty shoot-out. The winning kick,
scored by Antonin Panenka of Czecho-
slovakia, was a thing of beauty. From
Panenka’s long run-up and body shape,
the West German goalkeeper, Sepp Maier,
guessed that the kick would go hard to
his left. He dived in anticipation. But
Panenka did something novel. He calmly
chipped the ball down the centre of the
goal, which Maier had just vacated.
Armed with this story, we come
scrambling back to the present to con-
template another game of fine margins:
investment. Here too success often
depends on the ability to outwit others.
Indeed proponents of factor investing—
buying baskets of stocks with character-
istics that have been shown to beat the
market averages—say it works by exploit-
ing the enduring weaknesses of in-
vestors. If the dumb money keeps shoot-
ing for the corners, you profit by going
down the middle. Just hold your nerve.
This requires a faith that the future
will be like the past. And where there is
faith, there is always doubt. The world of
investing evolves, just as football has. As
more players adopted the Panenka,
goalkeepers cottoned on. A new category
emerged: the failed Panenka. A consider-
ation of this begs a scary thought for
factor investors: what if returns will be
hurt by the ubiquity of the strategy itself?
The roots of factor investing go back
at least as far as a canonical paper in 1992
by Eugene Fama, a Nobel-prizewinning
economist, and Kenneth French. They
found that listed companies that were
relatively small, or whose stock price was
low compared with the value of assets,
had higher-than-average returns. They
proposed that sizeand valuewere fac-
tors that justified a reward over andabove that for bearing market risk, known
as beta. Subsequent research identified
other winning factors for companies with
strong dividends (the yieldfactor) or high
profitability (quality); or with share prices
that have risen a lot (momentum) or that
fluctuate only a little (low-volatility).
Investors took notice. Trillions of dol-
lars are now invested in factor-based or
“smart-beta” strategies. A new paper by
James White and Victor Haghani of Elm
Partners, a fund-management firm, sets
out the reasons to be sceptical about their
continued success. A first problem is the
muddle over why factor premiums exist at
all. One view says it is all about risk. Small
or lowly valued firms are riskier because
they might go bankrupt in a really deep
downturn. You may buy that. But it is
harder to dream up a compelling risk story
about, say, momentum or low volatility.
The alternative view is that factors exist
because of the shortcomings of others. So
momentum works because investors in
general tend to react too slowly to good
news about a company’s prospects. Other
factor premiums are put down to industryfrictions. If, say, pension funds have
demanding targets, but are not allowed
to use leverage to boost returns, a sec-
ond-best strategy is to tilt the portfolio
towards high-volatility stocks. Low-
volatility stocks are thus unduly cheap.
The big question is whether we
should expect these quirks to endure.
Once a way to make above-market re-
turns is identified, it ought to be harder
to exploit. “Large pools of opportunistic
capital tend to move the market toward
greater efficiency,” say Messrs White and
Haghani. For all their flaws and behav-
ioural quirks, people might be capable of
learning from their costliest mistakes.
The rapid growth of index funds, in
which investors settle for an average
return by holding all the market’s leading
stocks, suggests as much.
Part of the appeal of index investing is
that it is cheap. Factor investing, by
contrast, involves a lot of churn—and
thus expense. A detailed study by aqr
Capital Management, one of the big
beasts of factor investing, finds that
trading costs were around 40% of gross
factor returns. The costs are mostly down
to the weight of money moving stock
prices unfavourably. This figure is high
enough to warrant concern, say the Elm
duo. It may go higher as more money
piles in. If factor premiums are also
slimmer in future, trading costs will eat
up a larger share of the extra returns.
What worked in the past cannot
always be relied on to work in future.
Penalty shoot-outs used to be seen as
lotteries; they are now exercises in data-
mining. Every goalkeeper and kicker
knows what his opponent has done in
the past. The best penalty-takers still
hope to induce the goalkeeper to move
first. But goalies are not as easily fooled.
They can hold their nerve, too.What if investors can learn from their mistakes?vance delivery of building materials. The
scheme has reached 600,000 households
and extended more than $300m of loans
since 1998.
Unlike business loans, which can be
paid back out of greater profits, lending for
housing creates no obvious income
stream. But home ownership frees borrow-
ers from paying rent. And some borrowers
use loans to build rental units, shops or
even schools. “Think of the house as a place
from where the household earns money,”
says Kecia Rust of the Centre for Affordable
Housing Finance in Africa, a think-tank.Habitat for Humanity recently commis-
sioned two evaluations of microfinance
products it had developed with lenders in
east Africa. In Uganda, the likelihood that a
household had a separate kitchen rose by
22% after taking out a loan. In Kenya, bor-
rowers upgraded their roofs and walls. In
both cases satisfaction with housing rose,
though stress levels and school attendance
were unchanged. Repayment rates have
been high. “We’ve proved there’s a business
case,” says Kevin Chetty of Habitat.
Microcredit is expensive, because lend-
ers must assess risk and monitor repay-ment on even the tiniest amount. Housing
loans are usually larger than business
ones, so processing them is proportionally
cheaper. But they also have longer maturi-
ties, which means lenders must chase
scarce long-term funding. Throw in pon-
derous law courts and weak competition,
and annual interest rates typically reach
20-35%. Some homebuilders are certainly
eager for credit. But until such structural
problems are addressed, others will keep
doing things the old way—even if that
means waiting longer to put a decent roof
over their heads. 7