They investigated whether mutual funds that had adopted certain factor investing strategies — low-risk (low-beta), small-cap, value, momentum, short-term reversal and long-term reversal — actually earn excess returns.

Over the study’s sample period, there was a small-cap premium of 20 basis points per month, a value premium of 33 basis points, a momentum premium of 60 basis points, a short-term reversal premium of 25 basis points and a long-term reversal premium of 43 basis points. The following is a summary of the authors’ findings:

• In terms of measuring one-factor alpha against a market index, small-cap and value funds deliver average alphas of 56 and 119 basis points per year, respectively, after costs. The returns of low-beta funds are indistinguishable from the market return, although these funds exhibit significantly lower levels of risk.
• Funds engaging in low-beta, small-cap and value strategies earn significant excess returns. Low-beta funds earn alphas that are, on average, 0.24 standard deviations above the cross-sectional mean, small-cap funds earn alphas that are 0.59 standard deviations above the mean, and value funds earn alphas that are 0.69 standard deviations above the mean. Importantly, these figures increased to 0.30, 0.93 and 0.88 standard deviations, respectively, over the second half of the sample period. And they were all highly statistically significant. Thus, there was no evidence of deterioration in the ability to add value over time.
• While only 1 percent of the non-factor investing funds earned an alpha of more than 5 percent per year, this figure is 7 percent, 11 percent, 12 percent and 7 percent for low-beta, small-cap, value and momentum funds, respectively. For both short-term and long-term reversal funds, however, there is no evidence of outperformance.
• For funds engaging in momentum strategies, there was mixed evidence of positive excess returns. The insignificant results for momentum funds may be attributable to the very small sample size of momentum funds in the study.
• For funds engaging in short-term reversal strategies, there was evidence of negative excess returns.
• The more strategies to which a mutual fund is exposed, the higher its alpha and success ratio.

In summary, the authors found evidence supporting the added value of funds that adopt low-beta, small-cap and value strategies. They concluded that the excess returns earned by these funds are sustainable and haven’t disappeared even after public dissemination of the anomalies.

They added this observation: “All in all, we conclude that there can be large added value of funds incorporating academic knowledge in their investment processes by engaging in factor investing. However, the incorporation of academic knowledge does not always appear to result in adding value… We find that factor strategies for which there is little documentation in the academic literature do not earn excess returns. It is important that empirical evidence withstands a significant number of attempts of falsification before investment strategies are engineered that incorporate this knowledge.”

Before concluding, there’s an important point to consider. The authors defined whether a fund had adopted a strategy by its exposure to that factor using a regression analysis, which is the way to determine if a fund provides exposure to stocks with the characteristics you’re looking at. However, a mutual fund can also use that factor by avoiding negative exposure to it.

For example, because value and momentum are negatively correlated, most value funds will have negative exposure to momentum. Some fund families avoid purchasing stocks that enter their defined buy ranges if they have negative momentum, delaying the purchase until the negative momentum ceases. The use of negative momentum screens significantly reduces the negative exposure to momentum that would otherwise exist. In addition, the funds will tend to hold onto positive momentum stocks a bit longer, giving priority to stocks with weaker momentum when selling. These funds wouldn’t show up on the author’s radar as funds that use a momentum strategy, even though in reality they are.