the premium is the pay for sitting through the drought

A friend forwarded me a value tilt fund last week. Few years in, it had gone nowhere, and he wanted to know if the whole idea was broken.

I pulled the long history before answering.

Value, measured as a factor, went flat to negative from 2007 all the way to 2020. Thirteen years. At the bottom, the drawdown was somewhere around 55 percent. That is the deepest and longest drought the factor has shown since 1963. Every smart beta brochure still quotes the long run premium, around three to four percent a year. Almost none of them quote the thirteen year wait that came attached to it.

Here is the part that catches people. A 55 percent hole needs a 122 percent gain just to climb back to flat. Value did recover, sharply, across 2021 and 2022. But whoever gave up at the bottom locked in the loss and handed the entire rebound to whoever was still holding.

What took me a while to really get is that the drought is not a flaw in the factor. It is the reason the factor pays at all. If a premium stopped hurting in the dry years, everyone would crowd in and arbitrage it flat. The discomfort is the toll. You are being paid to hold the thing other people cannot stomach holding.

A winter is different from a crash too. A crash is sharp and over fast. A winter just grinds, quarter after quarter of nothing, and that slow ache is what shakes investors out at exactly the wrong moment.

So before you buy any factor, ask one question. Can I sit through its worst winter without selling. Size it so a flat decade annoys you instead of breaking your plan.

A factor does not pay you for being right. It pays you for staying when the chart says you were wrong.

The math behind how factor premiums actually get paid, in plain words: