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.
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.