In the latest piece from Research Affiliates, Jason Hsu, Co-Founder and Vice Chairman, and Vitali Kalesnik, head of equity research, look at how  the “publish-or-perish” syndrome and the smart beta movement have motivated academics and practitioners to come up with a spate of new investment factors. How can investors determine which ones are legitimate and how to use them in their equity portfolios?

Finding Smart Beta: Factor Proliferation

When we were in the Ph.D. program at UCLA, we were taught the four-factor model in our asset pricing class. The world was simple; there were the market risk factor and the value, small-cap, and momentum return factors. The three non-market factors carried juicy return premia that could be had by investors willing to diversify into non-market exposures and exploit retail investors’ behavioral biases.

Fifteen years later, we are shocked to learn that some quant shops now use an 81-factor model to build equity portfolios. This inflation in factors has certainly made us feel inadequate and has potentially eroded the real value of our paper diploma. Understandably, we are concerned with the relentless onslaught of shiny, exciting, and sexy new factors introduced by bright-eyed, bushy-tailed young financial engineers.

Frankly, we expected the number of “accepted” factors to decrease rather than explode over time. We expected that at least one of the three documented anomalies would be revealed as a fluke—a data artifact that would disappear with better quality international data and with additional decades of out-of-sample data following the original discovery.

Indeed, that is what we have seen. The small-cap anomaly has not been observed in the United States since the early 1980s and does not exist outside the U.S. dataset (Table 1). This lack of “robustness” out-of-sample led Tyler Shumway and Vincent Warther to re-examine the small-cap anomaly; they concluded that it was likely driven by a mistake in how researchers treated missing data for delisted stocks. Apparently, missing returns for delisted stocks in the CRSP database created a systematic bias in the computed returns for small stocks, which are more likely to face delisting. When this bias is adjusted for, the small-cap anomaly is no longer observed (Shumway and Warther, 1999).

Finding Smart Beta

Finding Smart Beta in the Factor Zoo online at: “Finding Smart Beta in the Factor Zoo”

The tables on pages seven and eight of the PDF update the performance of the FTSE RAFI® Indices versus widely used benchmarks through 6/30/14.

Other research and commentary from Research Affiliates is available here.

Background on Research Affiliates is available here.