The new profitability factor, US and int'l evidence

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Re: The new profitability factor, US and int'l evidence

Postby RNJ » Wed May 15, 2013 6:35 pm

Roy wrote:
RNJ wrote:Here is the AQR Core Equity Fund Class N (QCENX). The "N" stands for NOT with respect to having the $5 Million minimum for the less expensive, presumably institutional class shares.

From the Vanguard site:

Large Value
Expense ratio as of 05/01/2013: 1.12%
Inception date 03/26/2013
Ticker symbol QCENX
12b-1 fee: .25%

Number of Stocks 244
Median Market Cap $22.7 billion
Price/Earnings Ratio 14.0x
Price/Book Ratio 1.7x
Earnings Growth Rate —
Foreign Holdings 0.1%
Turnover Rate (Fiscal Year End) —
Total Net Assets as of 04/30/2013 $1.1 million


Any takers?

Oh - did I mention that the top holding was good ol' Berkshire Hathaway Class B?


Thanks, RNJ. Unless I'm missing something, the Fees and Minimums are $1,000,000 for QCENX for initial investment. The top holdings do appear to be many of the usual "quality" suspects in a GMO (and others) sense. How they use Momentum to guide them is another thing.


I missed it. I guess the N also stands for NOPE :oops:

Thanks!
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Re: The new profitability factor, US and int'l evidence

Postby umfundi » Wed May 15, 2013 7:05 pm

Jebediah wrote:OverTheHill,

Wondering what do you make of this [nonsense --admin LadyGeek]?...

DFA Small Value (DFSVX), since inception (1993): Growth of 10K -> $103,681

Vanguard Total Stock (VTSMX), same period: Growth of 10K -> $55,228

Really? Here's what Yahoo Finance shows:

Image

I presume these are without distributions and without the advisor drag on DFA.

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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Wed May 15, 2013 7:10 pm

I didn't mean to derail the thread or propose a DFA vs Vanguard contest. My point was that I think it's hard to argue that there's not significantly different risk/return profiles happening in different corners of the market. And if so, why couldn't that differentiation be refined with further study? I wonder if Overthehill would agree, and if not I'm sincerely interested in hearing the counter-argument that goes beyond just attacking Larry personally.
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Re: The new profitability factor, US and int'l evidence

Postby umfundi » Wed May 15, 2013 7:26 pm

Jebediah wrote:I didn't mean to derail the thread or propose a DFA vs Vanguard contest. My point was that I think it's hard to argue that there's not significantly different risk/return profiles happening in different corners of the market. And if so, why couldn't that differentiation be refined with further study? I wonder if Overthehill would agree, and if not I'm sincerely interested in hearing the counter-argument that goes beyond just attacking Larry personally.

You made the post with totally incorrect data.

I apologize if that was not your point. We should not let the facts get in the way.

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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Wed May 15, 2013 7:33 pm

I chose the DFA SCV fund only because it has a long history.

Here's the Morningstar growth chart. Certainly they could have incorrect data, but this is what they have.

Image
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 7:44 pm

clearly irrational
Of course Larry is talking his book


Don't know why you said that. I don't have any "book" on this. I just presented the findings from Novy Marx' paper and from Zhang's etal paper and also from presentations I have seen so so far on the subject. I don't yet invest based on any of this. So have no "book" --at least not yet. I only go where the science or evidence takes me. There's no alliance or allegiance to DFA, Bridgeway, AQR or anyone else. We invest using the vehicles we think are the best at providing risk-adjusted returns for the asset classes we want exposure to. And it seems from everything I have seen so far that there is very strong evidence that including profitability will produce superior results.

The FF model does leave us with many anomalies, including for example the small cap growth problem. The Digesting Anomalies paper shows that their model which does incorporate profitability as well as an investment factor (which proxies for value)basically eliminates the anomalies.

What I don't understand is why is anyone so surprised that with all the manpower and computer power and profit incentive that we would not eventually come up with a better model, just as FF did.

I hope that is helpful

Best wishes
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Re: The new profitability factor, US and int'l evidence

Postby tc33 » Wed May 15, 2013 8:10 pm

Larry,

First, thank you for posting. Second, do you have any recommendations for how to incorporate funds that implement this strategy, particularly the DFA "growth" funds, into an investment portfolio?

I've been heavy DFA SV for about 10 years now, so TE not much of a concern. I'm not sure if these new funds are meant to supplant the tried-and-true SV funds or to be added as an additional diversifier/core fund. Ideally I would prefer a single "5-factor" global cap weighted fund, but short of that, how do I replicate such a thing? Thanks again!
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 8:46 pm

tc
Well we are still doing due diligence on fund providers but given what I have heard you don't have to do anything. If you are heavy with DFA SV that fund will begin to incorporate profitability some time in the not too distant future. And so will there other value funds. So don't think you really need to do anything. The three growth funds I believe were designed to fit the style boxes for those institutional investors that invest that way and DFA had no growth funds---hence their choice of name. Of course I'm purely guessing here but think it's a well educated guess.

I do think that the AQR funds look very interesting, too bad they have separate classes with higher fees for retail (direct) investors unless very high minimums. Even the funds we will have access to won't be as cheap as DFAs. But as I said they look very interesting, using a different multi-metric approach.

I hope that is helpful

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby scone » Wed May 15, 2013 8:53 pm

What I don't understand is why is anyone so surprised that with all the manpower and computer power and profit incentive that we would not eventually come up with a better model, just as FF did.

Do you recall the Myers-Briggs Personality Types? I think some people tend to find new information threatening, it shakes their settled, reliable, dependable view of the world. Other types restlessly seek out new information and find it interesting for it's own sake. You might call one type "farmers" and the other "explorers." I imply no judgment of superiority-- it takes all kinds to make a world. But there can be conflict when the two types meet and clash. My 2c, FWIW.
"Sometimes you eat the bear and sometimes the bear eats you." -- Preacher Roe
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Re: The new profitability factor, US and int'l evidence

Postby tc33 » Wed May 15, 2013 9:56 pm

larryswedroe wrote:So don't think you really need to do anything.

That's my favorite kind of action. Thanks for your response!

Please correct me if I'm wrong, but it seems like we're now trying to fit a square peg in a round hole, ie. 5-factor investing crammed into 3-factor style boxes, as these newer factors (MOM/PF) intuitively seem orthogonal (at least partially?) to S & V. I get it that DFA has to satisfy institutional investors, who, in turn, have to satisfy/communicate with Joe investor. For those of us without such constraints, it would be nice for a single DFA Awesome Equity fund ( great name, I know :D ) where they just apply their not-so-secret sauce to the entire investable universe and spit out alpha, regardless of M* style box. Or it is very possible I am not fully understanding these new factors; I'll have to review the literature.

Thanks again!
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 10:04 pm

Scone
That's very good analysis--my own experiences tell me you're correct.

TC
You basically have that in a two fund approach
DFA US Core equity and DFA international core equity

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Re: The new profitability factor, US and int'l evidence

Postby grayfox » Wed May 15, 2013 10:22 pm

Another book I'm reminded of by this is George Orwell's Animal Farm.

Get my drift?
Last edited by grayfox on Wed May 15, 2013 10:23 pm, edited 1 time in total.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Wed May 15, 2013 10:22 pm

I was asked about what anomalies the newer models explain that FF doesn't do good job at

Here's a list of at least some of them, might be some I am missing
Small cap growth
MOM
profitability
earnings surprises
Financial distress
net investment
net stock issuance


Again, those interested should read the Digesting Anomalies paper which addresses at least some of these issues.

I hope this is helpful

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Re: The new profitability factor, US and int'l evidence

Postby 3CT_Paddler » Wed May 15, 2013 11:27 pm

I keep seeing mention of using a similar methodology to Graham, but isn't Graham quoted as saying on here that he came to see the plain vanilla index strategy as superior? And how many people have tried to copy Buffett's exact approach without reproducing his returns? And how much of Buffett's success is partly due to the fact that he was able to buy stocks when they were very cheap during the 70's? (Obviously he still had to be smart and disciplined)

Ferri talks on here all the time about the critical importance of having a plan and sticking with it... reminds me of a quote... "the enemy of a good plan, is the dream of a perfect plan." Whether its TSM or some slice n dice, the important part seems to be sticking with it over the long haul.

Larry, it seems that every new year brings a new focus on what factor is most critical in here. A while ago it was all about momentum, now it is something else. It seems like its one small step from your strategy to an all out active management, stock picking strategy. How is this any different from active management? And aren't some of the five factors in conflict with one another? Momentum would seem to correlate with growth, not value stocks. Count me on the skeptical side that this is something any mutual fund can easily capture alpha long term by zeroing in on a couple well known measurables.
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Re: The new profitability factor, US and int'l evidence

Postby 3CT_Paddler » Wed May 15, 2013 11:51 pm

One thing to add...

Larry, what is the expected premium over TSM long term for this strategy?
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Thu May 16, 2013 12:11 am

Active funds are discretionary-- picks and timing dictated by the insight/intuition of the managers.
Passive funds are algorithmic-- picks and timing is determined in advance by a set of rules.
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Re: The new profitability factor, US and int'l evidence

Postby grap0013 » Thu May 16, 2013 12:27 am

Larry,

How well do you think Fundamental Indexes (FIs) capture this new profitability factor? Seems like cash flows/profitability are somewhat linked and FIs focus on cash flow as one of their value metrics.

This new metric only enhances my confidence in FIs. They also pass Larry's sniff test as they are logical, persistent, and implementable. I have often stated on here by simply sorting by price to book that it tells you nothing about a company. However, a company with a low P/B and it has good cash flow, earnings, sales, etc... it is only logical that it should have better returns than one that does not.
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Re: The new profitability factor, US and int'l evidence

Postby matjen » Thu May 16, 2013 7:57 am

Roy wrote:Thanks, Matjen (I like your Billy Jack avatar).


Thank you for giving my Billy Jack Avatar some props. I imagine it as Billy Jack giving some round house kicks to loaded mutual funds. :D I will admit that after trying the AQR fund I thought what the heck, let's see if I can actually place an order for a DFA fund. That got shut down right away. No preview of the trade, etc.
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Re: The new profitability factor, US and int'l evidence

Postby edge » Thu May 16, 2013 10:31 am

3CT_Paddler wrote:I keep seeing mention of using a similar methodology to Graham, but isn't Graham quoted as saying on here that he came to see the plain vanilla index strategy as superior?


He might have meant superior to individual stock picking.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Thu May 16, 2013 10:57 am

3CT_Paddler

I would very much disagree with your characterization. It's not that one new factor is more important--it's that a factor was found that helped explain returns more than we knew before hand. It's not that one is more important than the other. For example, the MOM premium and the profitability premium are both similar in size to the value premium. Note if you add one you lose exposure to the others due to the negative correlation between the first two and value. But a combination of them adds value,

Impossible to say how much a strategy of adding profitability adds to a portfolio because there are many ways to define it (just like with value) and it depends on what you are adding it to. And are you combining it with other strategies like MOM screens which already exist. What I can tell you is that the numbers are significant- And it's easily implementable

Grahams quote was meant as passive vs active not per se pure indexing or a TSM. AT least my view of his statements

Grap
Any metric that uses a profitability screen like price to cash flow will capture some of that, as you note. How much depends on what other metrics you use that don't have profitability in them like BtM. Also the further you go down the income statement the worse the factor performs--so a P/E doesn't work as well as price to cash flow.

For everyone else. There is a consistent error in "terminology" made here regarding the FF model.
The model never explained 90%+ of returns. What it does is explain 90%+ of the variance in returns between WELL DIVERSIFIED portfolios. The smaller the number of issues in the portfolio the more idiosyncratic risk and the worse the model performs.
And again, the new models that include profitability have similar explanatory power to the FF model but don't have the anomalies issues that the FF model does--making them superior models--enhancements to the FF work.

I hope that is helpful

Larry
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Thu May 16, 2013 11:17 am

larryswedroe wrote:For everyone else. There is a consistent error in "terminology" made here regarding the FF model.
The model never explained 90%+ of returns. What it does is explain 90%+ of the variance in returns between WELL DIVERSIFIED portfolios. The smaller the number of issues in the portfolio the more idiosyncratic risk and the worse the model performs.
And again, the new models that include profitability have similar explanatory power to the FF model but don't have the anomalies issues that the FF model does--making them superior models--enhancements to the FF work.

I hope that is helpful

Larry


Thanks, Larry. The explanatory issue seems commonly misunderstood and misdefined, even among some experts. Obviously, there a huge difference in what is actually shown vs. what is often stated. This is helpful in understanding what is being suggested by the newer model.
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Re: The new profitability factor, US and int'l evidence

Postby ScottW » Thu May 16, 2013 1:56 pm

umfundi wrote:Really? Here's what Yahoo Finance shows:
snip
I presume these are without distributions and without the advisor drag on DFA.

The chart you've displayed from Yahoo Finance shows the difference in share prices, not the total return. The total return for DFSVX over the past twenty years is much higher than the total stock market.
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Re: The new profitability factor, US and int'l evidence

Postby learning_head » Thu May 16, 2013 2:48 pm

larryswedroe wrote:For everyone else. There is a consistent error in "terminology" made here regarding the FF model.
The model never explained 90%+ of returns. What it does is explain 90%+ of the variance in returns between WELL DIVERSIFIED portfolios. The smaller the number of issues in the portfolio the more idiosyncratic risk and the worse the model performs.
And again, the new models that include profitability have similar explanatory power to the FF model but don't have the anomalies issues that the FF model does--making them superior models--enhancements to the FF work.

I hope that is helpful

Larry


Thanks Larry, this does help. So, are you saying that for WELL DIVERSIFIED portfolios FF explains 90%+ (98%+ actually?), but for NON-WELL DIVERSIFIED ones it explains much smaller percentage and new model is superior in those cases... Does this mean that for anyone sticking with WELL-DIVERSIFIED portfolios, new model will not carry any substantial advantage?
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Re: The new profitability factor, US and int'l evidence

Postby Scooter57 » Thu May 16, 2013 2:50 pm

Jebediah wrote:Active funds are discretionary-- picks and timing dictated by the insight/intuition of the managers.
Passive funds are algorithmic-- picks and timing is determined in advance by a set of rules.


Not necessarily true. If you fuss around with your algorithm enough it will be doing exactly what an active manager would be doing nowadays which is employing complex software-driven screens in real time to determine what stocks meet the criteria he or she uses to select stocks for the active fund.

Mind you, I like the Graham style of valuing stocks based on measures of growth and profitability and the likelihood that the stock will earn enough to support growing a dividend or a higher stock price. But to put in place very tricky algorithms that do on-the-fly analysis and produce a resulting "index" of stocks that meet complex performance and valuation metrics and call that indexing seems to me to have left behind the whole idea of indexing which is not to pick stocks based on measures of performance or valuation.

I'm sold on the idea of using TSM to get the market return, but I'm starting to think that the minute you start breaking markets down into arbitrarily chosen subsectors and treating that kind of indexing as if it were the indexing referred to by The Random Walk, you may be going out on a limb. If I was going to invest in value funds, I'd feel more comfortable with funds a real live human being had investigated after running algorithmic screens because you always have the problem of unquantifiable issues affecting a stock's future which may make it look like Value when it isn't.

The more I look at what is supposed to be value (Graham-style) in this market, the more I think you need to wait until the next big correction to buy Value. Every supposed value stock I've seen posted that has rising profits also has a significant story not reflected in the numbers that explains why investors are ignoring it. No algorithm is going to pick that up and be able to evaluate whether it is a short term phenomenon that represents an opportunity or a structural problem that will persist.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Thu May 16, 2013 2:51 pm

learning head
Any concentrated portfolio model won't work nearly as well because you have lots of idiosyncratic risks that a model cannot explain.
The big difference is that the FF model, while explaining a very high percent of the difference in returns between diversified portfolios leaves us with many anomalies --returns that the model cannot explain--I gave a list of them.

The newer models explain returns well AND you don't get the anomalies problems, or at least the model does a much better job of explaining them

Again, suggest reading the paper Digesting Anomalies

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Thu May 16, 2013 3:06 pm

Here's some monthly returns data thought you would find of interest on the profitability factor


High and Low Profitability Portfolios, US 1975-2012

High Low High-Low
Average 1.42 0.97 0.44
Std Dev 4.99 6.10 2.61
t-stat of difference 3.64

You can see why people have been impressed

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Re: The new profitability factor, US and int'l evidence

Postby edge » Thu May 16, 2013 3:34 pm

I tried reading the whole thread and got bored. I didn't get far enough to see if it answered why the length of data in the study was so short.

Also, don't you think enough me-too products will come out that will dilute these 'premiums'? I am not sure why one measurement of profitability (or 'quality') is really better than others - I can see that if too many products come out that focus on one or two of them it would wipe out any advantages they had historically.
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Re: The new profitability factor, US and int'l evidence

Postby Jebediah » Thu May 16, 2013 3:36 pm

Scooter57 wrote:
Jebediah wrote:Active funds are discretionary-- picks and timing dictated by the insight/intuition of the managers.
Passive funds are algorithmic-- picks and timing is determined in advance by a set of rules.


Not necessarily true. If you fuss around with your algorithm enough it will be doing exactly what an active manager would be doing nowadays which is employing complex software-driven screens in real time to determine what stocks meet the criteria he or she uses to select stocks for the active fund.

"employing" is the key word here. That's discretionary.

Mind you, I like the Graham style of valuing stocks based on measures of growth and profitability and the likelihood that the stock will earn enough to support growing a dividend or a higher stock price. But to put in place very tricky algorithms that do on-the-fly analysis and produce a resulting "index" of stocks that meet complex performance and valuation metrics and call that indexing seems to me to have left behind the whole idea of indexing which is not to pick stocks based on measures of performance or valuation.

Indexes have stock-picking rules. There are plenty that have value criteria. 500 is an arbitrary number. etc.

I'm sold on the idea of using TSM to get the market return, but I'm starting to think that the minute you start breaking markets down into arbitrarily chosen subsectors and treating that kind of indexing as if it were the indexing referred to by The Random Walk, you may be going out on a limb. If I was going to invest in value funds, I'd feel more comfortable with funds a real live human being had investigated after running algorithmic screens because you always have the problem of unquantifiable issues affecting a stock's future which may make it look like Value when it isn't.
The more I look at what is supposed to be value (Graham-style) in this market, the more I think you need to wait until the next big correction to buy Value. Every supposed value stock I've seen posted that has rising profits also has a significant story not reflected in the numbers that explains why investors are ignoring it. No algorithm is going to pick that up and be able to evaluate whether it is a short term phenomenon that represents an opportunity or a structural problem that will persist.

Then you would prefer active management to passive.
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Re: The new profitability factor, US and int'l evidence

Postby asinger » Thu May 16, 2013 7:45 pm

Larry,

Wondering if you had thoughts about tax efficiency for a combined mom + value + profitability strategy. Assuming there is no room in tax sheltered accounts for equities, would a combined CORE strategy make sense in taxable?

Concrete example: The AQR CORE equity funds rank equities with a weight of 40% mom, 40% value, 20% profits. The prospectus says turnover is expected to be in the 75%-95% range (vs. say, the tax managed momentum funds state expected 75% turnover).

A combined core fund would seem more tax efficient than separate funds, but would the expected out performance of the combined factors more than even out the additional tax consequences? Thanks!
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Thu May 16, 2013 8:33 pm

asinger
MOM is not as tax inefficient as people think because there are lots of short term losses and more long term gains---And yes a core fund makes much more sense for a variety of reasons, not just saving internal trading costs and improving tax efficiency but cutting need to rebalance!!!


Edge
The key driver of newer research was to move UP the income statement to look more at GROSS profitability, not net. This made a big difference in outcomes. The logic is that the further up you go on the income statement the less opportunity to manipulate earnings.



Hope that helps
Larry
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Re: The new profitability factor, US and int'l evidence

Postby edge » Fri May 17, 2013 10:16 am

Thanks, would like to see much longer backtest.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 11:48 am

edge
There is much longer backtest with the data available in the US and it is highly robust
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 12:00 pm

After reading many of the posts I think the following will help clear up some issues on this idea of the FF model explaining say 94% of the DIFFERENCE in returns of diversified portfolio and thus what value could adding another factor (profitability) add

First, when someone says that the model explains say 94% of the DIFFERENCE in returns, what they are saying is the r-squared is 94%.

Second, so say you run a three-factor regression and it shows r squared of 94, and now you run a regression with a fourth factor, profitability, and you get a similar 94 squared,

Third, the difference is that when you run a three factor regression on a portfolio with a loading on profitability is that you'll get the r squared of 94 but a big alpha, say 1%. In the second case the alpha would disappear.

This gets to the point I made that the FF model explains returns well, but leaves us with many anomalies that the model doesn't explain well (which is why the four factor model became the standard as the 3 factor model didn't explain MOM well), and you get big alphas with certain strategies, like tilting to profitability. This is NO DIFFERENT than in a CAPM world you might get a high r squared but a big alpha if you tilted to value.

The bottom line is that when you run the fourth factor you get both higher returns and you get a much higher t-stat--meaning that the data is more reliable, the premium is more reliable.
And we are talking about large t-stats.

That is occurring for two reasons
A) the premium is larger
B) you are diversifying the sources of returns/premiums and it happens that profitability and value are negatively correlated--and that reduces tracking error as well, and we know what a dread disease tracking error regret can be.


I hope this is helpful

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby Random Walker » Fri May 17, 2013 12:55 pm

So in the old VG versus DFA debate, does this new factor affect any individual investors thoughts? On the one hand it appears DFA will incorporate this new factor into its screens. On the other hand, this factor appears negatively correlated with value and might make some people more adamant TSMers. Seems DFA fans are happy to hear about improvements on the FF 3 factor model, while TSMers feel that better models only confirm the imperfection of models and their TSM beliefs further strengthened. Just curious what people think.

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Re: The new profitability factor, US and int'l evidence

Postby crake » Fri May 17, 2013 1:54 pm

Thanks all for your insights. This has been an interesting thread to read. After going through it all I think my question can be boiled down to this.

According to this new research tilting towards profitability can lead to an increase in expected returns. My possibly over simplistic way of thinking about where these excess returns come from leads me to two answers.

1) The investor is taking on additional risk.
2) Markets were pricing highly profitable companies incorrectly.

If the first scenario is true I do not see how this discovery helps investors. One could always take on more risk to increase returns. If the second scenario is true shouldn't prices correct now that this research has been released? Either way I don't see how this should impact the way anyone invests. If there is a third scenario I'm missing please let me know.

I also would like to ask a seemingly inflammatory question as nicely as I can. Larry, I am very grateful that you choose to share your knowledge in a public forum. Your posts are extremely enlightening to new investors such as myself. However, I can't help but be a little bit skeptical about you posting about new factors to increase returns, when the only way to access these new factors is through funds you sell or will sell. I can't help but think that if any other adviser came on this board touting new strategies to increase returns they would be promptly turned away. I mean no disrespect and believe you have the best intentions. I am just wondering if you have a good answer for my above questions and why we shouldn't be concerned about any conflict of interests.
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Re: The new profitability factor, US and int'l evidence

Postby grap0013 » Fri May 17, 2013 2:14 pm

Larry,

I am reminded of this article you wrote: http://www.cbsnews.com/8301-505123_162- ... -strategy/

Maybe you could run these four other factors over the same time frame of the profitability factor study to see how they directly compare?

Thanks!

grap
If you can't explain it simply, you don't understand it well enough.
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Re: The new profitability factor, US and int'l evidence

Postby Random Walker » Fri May 17, 2013 2:55 pm

Crake,
Under your case #1, I believe there is a huge difference between taking on more risk by adding more of the same risk versus adding some of a different risk. There is benefit to diversifying across risk factors. For example, for tilters the benefit of small and value is not just increased expected returns. It is also the relative lack of correlation of HmL and SmB with the market and each other. Don't know how much if any of the profitability story is risk, but the point is that if there is increased risk but of a different type than typical market beta, then there is potential benefit. This is especially true when looking from the viewpoint of the portfolio as a whole.

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Re: The new profitability factor, US and int'l evidence

Postby Roy » Fri May 17, 2013 3:04 pm

Random Walker wrote:Crake,
Under your case #1, I believe there is a huge difference between taking on more risk by adding more of the same risk versus adding some of a different risk. There is benefit to diversifying across risk factors. For example, for tilters the benefit of small and value is not just increased expected returns. It is also the relative lack of correlation of HmL and SmB with the market and each other. Don't know how much if any of the profitability story is risk, but the point is that if there is increased risk but of a different type than typical market beta, then there is potential benefit. This is especially true when looking from the viewpoint of the portfolio as a whole.

Dave


I agree with Dave on the types of risk and portfolio-as-whole emphasis.

My opinion is if there is not a risk story behind a factor, it is less likely to persist.
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Re: The new profitability factor, US and int'l evidence

Postby crake » Fri May 17, 2013 3:18 pm

Random Walker,

I think I understand what your saying, however, I still have some reservations. If I buy TSM I hold small value companies and I hold highly profitable companies. By "tilting" I am shifting from less risky assets to more risky assets with the expectation of higher returns. I believe you are stating the added benefit of tilting towards small value is that their returns have a low correlation to the overall market. If this wasn't true then one could get the same advantage tilting has by decreasing the bond portion of your AA and adding more equity.

If I am understanding correctly, the case for small value tilting is the low correlation with overall market returns, not the higher expected returns themselves(since one can get higher expected returns by simply increasing their equity exposure). If what I'm saying is true (which it might not be) then wouldn't the important thing to discuss be the correlation between profitable companies and the market as a whole?
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Re: The new profitability factor, US and int'l evidence

Postby Random Walker » Fri May 17, 2013 3:20 pm

And I agree with Roy :happy . Although human behavior is amazingly consistent over generations, I have a lot more faith in risk stories than behavioral ones. Although I do think a behavioral component can only help the value story. Of course the longer the period demonstrating a source of return, even if its behavioral, the more I believe it.
I like the way Larry succinctly describes how we should evaluate new information. Longer time periods are better, out of sample confirmation, plausible story to explain the data.

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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 3:27 pm

Dave
So in the old VG versus DFA debate, does this new factor affect any individual investors thoughts? On the one hand it appears DFA will incorporate this new factor into its screens. On the other hand, this factor appears negatively correlated with value and might make some people more adamant TSMers. Seems DFA fans are happy to hear about improvements on the FF 3 factor model, while TSMers feel that better models only confirm the imperfection of models and their TSM beliefs further strengthened. Just curious what people think.


The fact that the profitability factor negatively correlates with value is a very good thing for tilters to value--it helps by then reducing portfolio volatility without negatively impacting returns--in fact increasing them at same time--as you pick up a diversification return and the two premiums are similar in size.

Crack
No problem. First from an investment standpoint the only thing my firms sells is advice. We don't sell any products, don't get paid to sell any products, and the only ones paying us are our clients. We have no incentive to favor one family over another except if it is in the best interest of our clients. If by paying more fees to DFA that reduces the client's net worth we lose because our fees are based on client AUM. We also have a fiduciary responsibility to choose the best vehicles. When DFA is the best choice in our opinion we have used them, when they are not, we use others. We have used for example TIAA product and currently use Bridgeway as well and now looking at AQR also. More importantly I'm sure as the sun rises in the east that there will be other fund families that incorporate the profitability factor with the research now public for a while. In addition, as others have noted AQR is available through the public and I can tell you I'm very impressed with the firm in general, the talent they bring to the table is as good or better than any in the industry, and the structure of the new funds is excellent. Finally, I would add that all I try to do is to bring the research to people so that they can make informed decisions. What they choose to do with the information is of course up to them

Second, as to risk, first the math is simple as I said, higher returns simply because stocks with higher profitability and same valuation have higher expected returns. As to risk, it certainly could be argued it's market mispricing--but that should matter it's still higher expected returns. And there are many examples of anomalies persistenting due to institutional constraints, limits to arbitrage, costs of shorting and so on, let alone human behavior not changing. Having said that I did lay out a risk story, one provided to me by Novy-Marx by the way, which makes perfect sense. But again, here don't make the mistake of thinking in isolation. As another poster pointed out adding factors so you diversify across more factors is a good thing, not having all eggs in one beta basket which TSMers have (they think they are well diversified because of number of stocks and asset classes they hold, but they are not diversified by factors, or sources of return, at all. All eggs in that beta basket. IN the cases of prof and MOM these are particularly good for tilters because they both negatively correlate with value, and thus reduce both tracking error risk and volatility of portfolio--meaning you also get lower drawdowns!!! Thus you REDUCE risk.

I hope that is helpful.

Larry
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Re: The new profitability factor, US and int'l evidence

Postby Random Walker » Fri May 17, 2013 3:29 pm

Crake,
Yes you are on the same page of the play book as me for the most part. Small and value do have higher expected returns and there correlations provide excellent diversification benefit. The above posts indicate that this new profitability premium is negatively correlated to value. So that makes it sound like an excellent diversifier. But where I am confused is that if adding some tilt is this direction just takes one back towards a TSM type portfolio.
From reading the thread, I'm inclined to believe the answer to that question is NO. It seems that this profitability factor can fairly easily be added as an additional screen after screening for value to improve upon a value fund. Curious to read more.

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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 3:40 pm

few things
First for grap, you might want to read the Novy Marx paper which has the data or my summary here http://www.cbsnews.com/8301-505123_162-57542953/a-new-way-to-be-a-value-investor/

Second, for Dave and Crake, moving to profitability doesn't take you back to a TSM portfolio, at least not to any meaningful degree. When you look at adding say profitability screens to a DFA core type portfolio here is what you find. (Keep in mind the core portfolios are tilted slightly to size and value, with core 1 having about a 10% loading on each and core 2 about 20% loading on each.) When you run a factor regression on it you find that the loadings to size will go down some (larger companies tend to be more profitable so they are more heavily weighted and thus lowering the size tilt) and value stays basically the same and so does mom. But you get a big alpha! Now if one can explain why you would not want to do that I would be very interested in hearing about it.

Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby Roy » Fri May 17, 2013 3:50 pm

Random Walker wrote:And I agree with Roy :happy . Although human behavior is amazingly consistent over generations, I have a lot more faith in risk stories than behavioral ones. Although I do think a behavioral component can only help the value story. Of course the longer the period demonstrating a source of return, even if its behavioral, the more I believe it.
I like the way Larry succinctly describes how we should evaluate new information. Longer time periods are better, out of sample confirmation, plausible story to explain the data.

Dave



Yes.

Larry has also shown many papers explaining why the riskier assets have those risks and how they tend to show in crises. Thus, greater premia are demanded for holding small and value stocks. Though, I think their premia also persists because when the risks do show up, investors flee at even faster speed, thus depressing prices and ensuring better future returns (also true for the market equity portfolio over bonds). For me, that is where the behavior part lies.

With the Quality stocks, perhaps the reason they (will) persist is because more exciting names always come along for investors to chase and they do—not wanting to be left out of the better deal. Thus, Coca Cola and (insert other resilient Buffet stocks) become boring but their resiliency makes them interesting after the fact, at least until the next hot items get chased. And though harder to find, this (whatever Quality is) apparently exists across asset classes and internationally. The GMO guys have written on this factor too.
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Re: The new profitability factor, US and int'l evidence

Postby crake » Fri May 17, 2013 3:58 pm

Larry,

Thanks a lot. This thread has been extremely informative.

Right now my assets are relatively small (under 6 figures) and spread out across accounts so I don't really have room for slicing and dicing. For the time being the simplicity of market weight indexing is worth the possibly lower returns I'd get from tilting. Perhaps in the future when my portfolio is larger and more defined I can revisit this tilting question.

Thanks for clearing the issue with regards to your objectivity. I'm glad that you choose to share your findings and help explain them in this forum.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 4:11 pm

crake
The nice thing is that you don't need lots of assets to tilt -even to profitability, especially with core funds now available like AQRs which expose you to
US, large and small and also value, MOM and profitability and so does their international fund
And you certainly can tilt using other (non-DFA vehicles) like RAFI's and Wisdom Tree's and other low cost ETFs--and I'll bet just as we see low VOL products now you'll see high profitability products
Best wishes
Larry
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Re: The new profitability factor, US and int'l evidence

Postby grap0013 » Fri May 17, 2013 5:12 pm

larryswedroe wrote:few things
First for grap, you might want to read the Novy Marx paper which has the data or my summary here http://www.cbsnews.com/8301-505123_162-57542953/a-new-way-to-be-a-value-investor/

Second, for Dave and Crake, moving to profitability doesn't take you back to a TSM portfolio, at least not to any meaningful degree. When you look at adding say profitability screens to a DFA core type portfolio here is what you find. (Keep in mind the core portfolios are tilted slightly to size and value, with core 1 having about a 10% loading on each and core 2 about 20% loading on each.) When you run a factor regression on it you find that the loadings to size will go down some (larger companies tend to be more profitable so they are more heavily weighted and thus lowering the size tilt) and value stays basically the same and so does mom. But you get a big alpha! Now if one can explain why you would not want to do that I would be very interested in hearing about it.

Best wishes
Larry


So the all four value sort produced an annual premium of let's say 5.5% where as a P/B + profitability sort premium was closer to 7 or 8% annualized? Sound about right?
If you can't explain it simply, you don't understand it well enough.
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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 8:36 pm

grap
No. Each 0.1 percent loading on size AND value gets you about 80bp in expected returns. So a core 1 type portfolio would have outperformed, be expected to outperform TSM by about 80bp. A profitability filter or ranking would add something onto that

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Re: The new profitability factor, US and int'l evidence

Postby larryswedroe » Fri May 17, 2013 8:47 pm

here's some more data
75-12
High profitability minus low profitability 4.9% with tstat of 3.5 when defining profitability as EBITDA over book value
Take out interest expense and it's even higher at 5.3% with 3.6% tstat
Net income to book it's 3.8% with tstat of 2.8

As you see the higher up the income statement you go the more powerful the data becomes

Also for the period since 1991 where data available the premium on "direct profitability" the highest up the chain, was even higher in developed market at 5.5% and higher still in EM since 1995 at 6.1%

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Re: The new profitability factor, US and int'l evidence

Postby swaption » Fri May 17, 2013 9:47 pm

larryswedroe wrote:And there are many examples of anomalies persistenting due to institutional constraints, limits to arbitrage, costs of shorting and so on, let alone human behavior not changing.


There is already a term for this, it's called alpha. But DFA and others would never claim to generate alpha. Simply put, if it's not a risk story, it's alpha. We generally don't expect anomalies to persist. Before making changes to one's portfolio, why should one expect this to be different? You have given generalized examples of what can give rise to anomalies, but I don't see how any of those apply here.
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