The Incredible Shrinking Factor Return

30 Pages Posted: 22 Sep 2017

See all articles by Robert D. Arnott

Robert D. Arnott

Research Affiliates, LLC

Vitali Kalesnik

Research Affiliates Global Advisors

Lillian J. Wu

Research Affiliates, LLC

Date Written: April 2017


This is the first in a series of papers we will publish in 2017 that demonstrate factor tilts generally deliver far less alpha in live portfolios than they do on paper, or put another way, investment managers generally fail to capture the returns that would be expected based on their factor tilts. We break our research into four parts. In this paper we show that the factor returns realized by fund managers differ starkly from the theoretical factor returns constructed from long–short paper portfolios. Notably, the market, value, and momentum factors are far less rewarding in live fund management than their theoretical long–short paper portfolio returns.

In the second paper of the series, we challenge the idea that factor tilts — portfolios combining several theoretical factor portfolios — are the same as smart beta strategies. We show, using Fundamental Index™, equal-weight, and low-volatility strategies as illustrative examples, that factor tilts cannot successfully replicate smart beta strategies. Although the factor tilts of these strategies are easy to replicate, the resulting portfolios look very different from the originals, with the replication portfolios having far higher turnover, lower performance, and smaller capacity.

In a third paper of the series, we show that the relative valuations of factor loadings can give us the courage to buy mutual funds when factor tilts are at their cheapest, hence, the most out of favor. Along with fees, turnover, and past performance — where low fees, low turnover, and low (yes, low!) past performance are predictive of better future returns — factor loadings can help us improve our forecasts of fund returns. We find the best predictor is prior three-year performance, but with the wrong sign: buying the losers is the winningest strategy.

Finally, a fourth paper will take a closer look at momentum, for which we find the realized alpha in live portfolios is essentially zero compared to a theoretical alpha of around 6% a year. We show why momentum doesn’t work in live portfolios, and also show how momentum can be saved as a useful source of alpha.

Keywords: factor return, factor tilts, smart beta

JEL Classification: G10

Suggested Citation

Arnott, Robert D. and Kalesnik, Vitali and Wu, Lillian J., The Incredible Shrinking Factor Return (April 2017). Available at SSRN: or

Robert D. Arnott

Research Affiliates, LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8700 (Phone)
949-325-8901 (Fax)


Vitali Kalesnik (Contact Author)

Research Affiliates Global Advisors ( email )

16 Berkeley Street
London, W1J 8DZ
United Kingdom
+44 2039299880 (Phone)

HOME PAGE: http://

Lillian J. Wu

Research Affiliates, LLC ( email )

620 Newport Center Dr
Suite 900
Newport Beach, CA 92660
United States

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