Abstract
This study investigates whether the profitability of various factor investments is sustainable after costs due to price impact, and estimates the capacity of strategies in the Korean stock market. With various initial amounts invested as of the end of December 2000, we analyze after-cost-returns on factor investing during the period from January 2000 to December 2017, and estimate the break-even fund size and maximal profit fund size. To this end, whenever rebalancing factor-investment portfolios based on trading rules, the number of shares of stocks to be bought and sold is computed and the price impact costs of the transactions are taken into account. This procedure computes the implicit cost of trading of factor investing to produce after-cost-returns for various initial amount invested. While the momentum and value factors perform well before price impact costs, the profitability factor performs better after price impact costs. More specifically, the break-even fund size is estimated to be 1.4 trillion Korean won (KRW), and the maximal profit generating fund size is estimated to be 750 billion KRW which could attain a monthly net profit of 1.9 billion KRW over the sample period.
Highlights
Factor investing is an investment strategy based on market anomalies that have been observed from past data [1,2,3,4,5]
We address the second question of how the price impact costs affect the profitability of factor investing and estimate the capacity of each factor investing strategy in the Korean stock market
We provide the entire profile of the fund profits and returns depending on fund size
Summary
Factor investing is an investment strategy based on market anomalies that have been observed from past data [1,2,3,4,5]. A growing amount of passive funds are using factor-based investment strategies. There is criticism that factor investing is not appropriate for the management of pension funds which should pursue stability and sustainability because the effectiveness of factor investing has not yet been verified and is still controversial among practitioners and academics [6,7,8,9]. The effectiveness of factor investing is investigated by a so-called back-test which simulates the investment strategy following its own logic of portfolio selection with historical data. The inevitable flaw of back-tests is the fact that past profits do not guarantee future profits
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