BOTW 14: Systematic Factors

A long/short portfolio created by ranking factor ETFs using rolling Sharpe Ratios beats the market.

After breathing the rarefied air of dividend aristocrats for our last two backtests of the week, we're ready to get our hands dirty on the quotidian and perennial question of factor investing. Does it capture persistent market anomalies or are the risk premia associated with those factors as unstable as the time series they follow?

As you can imagine, for a short blog like this we won't be able to answer that question definitively or even touch on the stacks of scholarly papers dedicated to debating one side or another. Instead, like the quanttards we are, we'll use the data available to come up with an answer for ourselves. But first, a little history. In their seminal paper, The Cross-Section of Expected Returns, the godfather's of the space, Eugene Fama and Kenneth French's challenged CAPM, beta, and put factor investing on the map. Explaining returns beyond just market risk was a novel idea. Identifying small-cap value as an anomaly set off a flurry of funds and follow-on papers to exploit or to dispel the finding. Since then, factors have proliferated as academics sharpened their pencils and benchmark providers padded their wallets. Today, investors have "widely adopted" systematic factor investing, according to S&P Global, though we'd like to see the evidence of such. The reason: enhancing risk-adjusted returns over the long term. But, as S&P notes, "empirical evidence indicates that the performance can vary significantly depending on the prevailing economic environment." Is that a surprise?

Prior to 2015, investing in the Fama-French et al. factors would have been difficult for all but institutional investors. Since then, a number of ETFs, many offered by Invesco (not advertising unless Invesco would like to sponsor this blog by purchasing 1,000 subscriptions!), have gone public that track these factors by tracking the S&P indices of said factors created out of the S&P 500. Way to cross-sell those indices! Now that such factors are investable for Joe Investor, we wonder if it would be possible to construct portfolios of those ETFs that would outperform the S&P. Welcome to another backtest of the week!

The major investable factors in ETF form are SPHQ, SPMO, RPG, RPV, SPLV, SPYD, and RSP representing quality, momentum, growth, value, low volatility, high dividend, and size. While high dividends aren't a core academic factor, they are included in the S&P indices, so we might as well use them. Equal weights are also not a factor, but, since we aren't actually including small caps in this test, it's good enough. And, S&P includes it in their factor indices too, so why should we let logic get in the way of charging for another index feed? Let's have a quick glance at the cumulative returns to all the factor ETFs along with the S&P (e.g., SPY) itself.