Scientific Beta warns of factor-investing risks

A Scientific Beta study has highlighted the risks of deviating from academically validated factors and the limitations of many popular factor-investing solutions.

A new study, “The Risks of Deviating from academically Validated factors”, has found the following dangers of not adhering to academic consensus when it came to factor investing:

• Factors used in investment practice showed a stark mismatch with factors that documented by financial economists;
• Commercial factors were based on complex composite definitions that offer maximum flexibility. Providers used this flexibility to seek out the factors with the highest performance in a given dataset; and
• Such practice allowed spurious factors to be found.

This type of practice led to the presentation of in-sample performances that have very little chance of being reproduced out of sample., the firm said.

Commenting on the study, Professor Noël Amenc, chief executive of Scientific Beta, said: “Understanding the factor drivers of returns increases transparency and allows investors to formulate more explicit investment choices.

“However, being aware of exposures to useless factors, which have no reliable link with long-term returns, is pointless.

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“For a meaningful contribution to the ability of investors to make explicit investment choices, factor investing should focus on persistent and externally validated factors. It is time to recall the good idea of factor investing.”