Factor investing criteria needs examination
Investors have been warned to examine the criteria used by fund managers involved with factor investing, stating that some of the strategies only work well in the short-term or have only shown good results in back-testing and not actual current market conditions.
Smart beta researcher and strategy provider, ERI Scientific Beta, stated while academic research has been conducted on the application of factors to index investing, a number of providers were creating their own factors and applying them inconsistently to funds and in contrast to generally accepted principles.
In a paper titled ‘Pimp My Factor? A Critical Comparison of Factor Definitions', ERI Scientific Beta, stated that some factor investing managers were "not only inconsistent with factor definitions in the academic literature, but are also inconsistent concerning the factor definitions across their own indices".
It pointed to one unnamed manager which had defined its value factor as "book to price and earnings yield" in the value component of a multi-factor index, but then defined value by "cashflow yield, earnings yield, and country-relative sales-to-price" in their single factor value index.
The group said fund managers who use factor investing, typically but not exclusive index managers, used their own proprietary definitions to increase their flexibility in testing variations of those and other factors but this approach and departure from academic benchmarks created a risk of data-mining.
"Inconsistent factor definitions across different indices from the same provider further increase the number of potential variations of indices, and thus open the door to data-mining. This is even more the case when it remains unclear why these adjustments are made or why different indices require different definitions," the paper stated.
"In particular, it is often unclear whether there are any fundamental economic reasons for using particular variables and adjustments for a given factor. In fact, it appears that providers sometimes explicitly aim at selecting ad-hoc factor definitions which have performed well over short-term back-tests."
ERI Scientific Beta said the selection of proprietary factor or combinations of factors or making proprietary tweaks to variable definitions boosted the performance of a factor index in a back-test but questioned whether these changes would hold going forward, particularly in the absence of solid economic foundations.
"Perhaps even more importantly, it is unclear what - if anything - factors with extensive proprietary tweaks still have in common with the factors from academic research."
"In the absence of a clear relation with academic standard factors, such proprietary factor strategies are merely ad-hoc constructs resulting from product back-tests."
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