How Trading Costs Erode Factor ReturnsAdvisor Perspectives
When choosing a factor-based strategy, advisors should carefully scrutinize the fund’s construction rules (e.g., the number of securities held) and implementation strategy (e.g., the frequency of rebalancing and the use of patient, algorithmic trading).
To understand the importance of this issue, let’s go back to our book, “Your Complete Guide to Factor-Based Investing,” in which Andrew Berkin and I laid out five criteria that must be met before considering investing in a factor. The factor must show evidence of being a unique/independent source of risk that has generated a premium that is:
- Persistent – It holds across long periods of time and different economic regimes.
- Pervasive – It holds across countries, regions, sectors and even asset classes.
- Robust – It holds for various definitions (for example, there is a value premium, whether it is measured by price-to-book, earnings, cash flow or sales).
- Investable – It holds up not just on paper but also after considering actual implementation issues, such as trading costs.
- Intuitive – There are logical risk-based or behavioral-based explanations for its premium and why it should continue to exist.
We then laid out the evidence that, among the “zoo” of equity factors documented in the academic literature, only a handful pass all the tests: market beta, size, value, momentum and profitability/quality. It is particularly important to consider transactions costs (investability) because market impact costs may substantially erode a strategy’s expected excess returns. Transactions costs are impacted by not only turnover (due to the need to rebalance portfolios) but also concentration of turnover and thus demands on liquidity.
Feifei Li, Tzee-man Chow, Alex Pickard and Yadwinder Garg contribute to the literature with their study “Transaction Costs of Factor-Investing Strategies,” which appears in the Spring 2019 issue of the Financial Analysts Journal. The authors evaluated 15 popular factor investing strategy implementations and identified how index construction methods, when thoughtfully designed, can reduce market impact costs.
The authors began by noting: “It stands to reason that excess returns grow scarcer as AUM rises: managers must buy more of the stocks in their opportunity set, creating upward price pressure that inexorably lowers the expected return. Conversely, when they exit existing positions, their trading generally pushes prices down, reducing the realized return.” They added: “Impressive backtest returns may be achieved by holding concentrated portfolios with high turnover rates, and strategies that require specific selection criteria can exhibit these characteristics. A backtest is not an accurate representation of an investor’s experience because it only simulates the history of a strategy and does not incur actual asset-related trading activity and associated costs.”
To determine the impact of implementation costs, the authors analyzed the behavior of stocks that were traded during the rebalancing of 49 FTSE RAFI™ Indexes, which represents live histories and approximate total assets under management (AUM) of $8 billion in 2009 to $74 billion in 2016. Following is a summary of their findings:
- There is significant evidence of market impact on the rebalancing day and a subsequent price reversal over the next four days, costs induced by the orders of the indexers.
- The magnitude of price impact is predictable because it is directly related to the security’s liquidity and the size of the trade.
- A fund incurs approximately 30 basis points (bps) of trading costs due to market impact for every 10% of a stock’s average daily volume (ADV) traded in aggregate by the factor investing index-tracking funds.
- With as little as $10 billion in AUM, momentum indexing strategies can have trading costs of 200 bps or more.
- Dividend income and dividend growth strategies also incur high costs due to high concentration, leading to high market impact costs. Costs are in the 60-80 bps range. On the other hand, quality strategies’ costs fall below 40 bps and value strategies’ below 30 bps. The results were similar in international markets.
- Mixing factors together diversifies the holdings and reduces turnover concentration.
- Factor strategies that invest in small subsets of the market (such as momentum) tend to have high turnover concentration because they routinely require that the manager completely eliminate a few existing positions and buy into new positions. Broad market indexes that reweight constituents back to predetermined and stable weights tend to have lower turnover concentration.
- Strategies that rebalance more frequently, such as quarterly versus annually, will tend to have lower turnover concentration.
Read the full article here by Larry Swedroe, Advisor Perspectives