Factor Decay

Recently John Cotter and Niall McGeever posted an interesting paper to ssrn.com. They studied the persistence of nine anomalies in the U.K. equity market:

·       Accruals

·       Asset growth

·       Book to market ratio

·       Profitability

·       Stock issuance

·       Return reversal

·       Momentum

·       Equity turnover

·       Size

They found a general decline in the profitability of these factors from 1990 to 2013. On average, the annual excess return dropped about 50% between 1990 to 2001 to the 2002 to 2013 period. Eight of the nine factors decayed. Momentum disappeared completely.

This is important for all traders, not just long-term equity investors. First, this is a specific example of a more general alpha decay effect. Second, equity factors are probably inefficiencies rather than compensation for risk and, as I wrote recently, inefficiencies are particularly prone to decay as they are more studied. My personal thinking is that trades based on risk premia (e.g. the variance premium, carry or credit) are more likely to persist.

Euan SinclairComment