Does multifactor investing live up to its hype?

CHICAGO — For a while, it seemed as though I couldn’t go to a financial conference without hearing the terms smart beta or factor investing at least once every few minutes. That’s not happening anymore. Perhaps it’s because the evidence hasn’t backed up the hype.

While money has poured into smart beta funds, they are underperforming. If you consider small-cap value funds a proxy for smart beta, as I do, they have lagged large-cap growth funds by 5.6% annually over the past five years through June 11, according to Morningstar data.

Yet experts continue to tout these instruments. At a panel on the topic at the Morningstar Investment Conference, speakers were enthusiastic. Vanguard views factor investing as an active strategy, said Antonio Picca, the firm’s head of factor-based strategies, and he noted that Vanguard has recently launched a multifactor and single factor set of funds.

I was afraid I wouldn’t hear it, but Morningstar research analyst Adam McCullough finally mentioned factors are back-tested and may not work going forward, especially if money pours into them. The panelists said they felt comfortable their funds were not doing this. I couldn't disagree more.

I couldn't keep quiet any longer. I stepped up to the microphone and asked the panel about the poor performance of factor investing. I noted Research Affiliates founder Rob Arnott's warning that smart beta can go terribly wrong. I asked why they were so sure they weren't just performance-chasing.

All panelists said they thought I brought up an interesting point but felt their firms had validated their factors and noted the intuitive logic of the factors they had picked. Maybe it's just me, but behavioral economics shows intuition is based on emotion, which fails us miserably in investing.

The panel noted that factor investing was a long-term commitment. I agree with them on this point, as moving back and forth between factor- and cap-weighted is just another form of performance chasing.

I'm pretty sure my question did not make me the most popular person in the room. But I'm not totally against factor investing. I think low-cost factor investing is a viable long-term active strategy. Two things make me more optimistic on its future. First: The recent underperformance, combined with my belief in reversion to the mean. Second: The fact that the subject is no longer dominating financial conferences.

In other words, this once-hot strategy has cooled off.