Severe criticism of DFA's "profitability" factor research

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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Thu Sep 12, 2013 12:19 pm

Browser
While I understand your point and the concerns that is why before making any "extrapolations" one should put the theory to the various tests I suggested
Does it persist over long periods?
Does it persist across asset classes?
Does it persist across markets?
Is the data statistically significant in each of the cases?
Is there a logical explanation, either behavioral or risk?
Can it survive transactions costs and for taxable accounts taxes as well?

The stronger the answers the more confidence one can have in the data and ability to set expectations about what is likely (not certain) in the future.

IMO this passes all the tests with possible exception of the logical explanation (but the math is simple and it must be so-only thing we don't know is why it exists). It's no different than other cost of capital "stories."

Obviously each person can decide for themselves on the issue.
I hope that is helpful

Larry

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Re: Severe criticism of DFA's "profitability" factor researc

Post by nisiprius » Thu Sep 12, 2013 3:37 pm

thx1138 wrote:
Browser wrote:Unlike true science, which can make and precisely test predictions based on theoretical models, economics involves the reading of tea leaves and then looking for patterns in cloud formations that subsequently form in order to discover some sort of confirmation.
I'll let the astronomers, cosmologists, geologists, evolutionary biologists, climatologists and a whole host of other scientists know they aren't doing "true science" :happy
Did you mean to include astronomers? Because they were on time to the minute when I took this snapshot on June 8, 2004.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by thx1138 » Thu Sep 12, 2013 3:51 pm

nisiprius wrote:Did you mean to include astronomers? Because they were on time to the minute when I took this snapshot on June 8, 2004.
I sure did. Your example is what astronomy was pioneering two centuries ago. And a very good example of what people think modern science is doesn't match what science is actually doing these days. What astronomers do today is things like:

- Extract vanishingly small signals to try to model star and planet formation, and do this from tiny populations and incredibly noisy data
- Extrapolate fundamental laws to untestable scales and then attempt to apply small corrections to those laws based off of incredibly noisy data (dark energy/matter)
- Create complicated models of solar dynamics based off of reams of very noisy data that don't exist over significant enough time scales
- Attempt to establish scales of the universe using "standard candles" that aren't very standard and suffer from unpredictable attenuation effects, many of which are temporal and infrequent (cosmology)

And so forth...

There isn't anything easy or deterministic left in astronomy. That was all done by "gentlemen" scientists a few centuries ago. Today it is all noisy data from small populations often with models with far too many free parameters given the number of constraints. So - surprisingly like the troubles economists have.

Oh, and by the way nice picture! We did get to see the 2012 event but missed the 2004.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Valuethinker » Thu Sep 12, 2013 3:59 pm

Browser wrote:I found this article by Michael Edesess to be quite provocative. He raises some serious criticisms about DFA's recent research on "profitability" as a new "factor" explaining equity returns and argues it's flaws demonstrate pseudo-science.
Dimensional Fund Advisors (DFA) is a company with a laudable history, founded on solid principles and a valuable product concept.
But I am afraid the company has succumbed to a dreadful descent into scientism.

The famed Austrian economist Friedrich Hayek defined scientism as “slavish imitation of the method and language of science” when applied to the social sciences such as economics. Scientism takes on the trappings of science without its depth or rigor.

DFA recently advocated for tilting an equity portfolio toward companies with higher profitability. The company’s argument begins with a spurious pseudo-mathematical “derivation” of a reason why companies with higher profitability should have higher expected returns. It then, without further ado, enshrines the results of this deeply flawed analysis into theory, using phrases such as “financial economics shows that…,” as if the principle were an integral part of a long-standing and thoroughly proven theoretical framework. DFA provides historical evidence for the relationship that is poorly presented and looks suspicious. Then, without further discussion or explanation, the company simply extrapolates the results found in historical returns to become “expected returns” – all the while displaying with each exhibit the obligatory statement: “Past performance is no guarantee of future results.”

Pardon my cynicism – if that’s what it is – but something is seriously wrong here. The facade of science that the industry presents – of which DFA is only one example – is nothing more than that, a facade, and an especially transparent one at that.

DFA’s justifications for its portfolio tilts toward small stocks and value and now toward profitability are presented as the results of scientific findings. But they are all extrapolations of past results into the future. At least one of these tilts – toward small stocks – has already proved questionable, as I have previously shown. Past outperformance of an investment strategy has almost invariably been shown to be an unreliable indicator of future performance. Will we ever move beyond lip service to this ubiquitous warning?

Edesses' tone is perhaps a bit extreme.

However he's a good guy-- smart analyst.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by nisiprius » Thu Sep 12, 2013 3:59 pm

thx1138 wrote:Oh, and by the way nice picture! We did get to see the 2012 event but missed the 2004.
Other way around for me. Bad weather in 2012. But, hey, it was a twice-in-a-lifetime event and I got to see it once.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Levett » Thu Sep 12, 2013 4:48 pm

Scientism fits.

A simple Google search uncovers the claimants.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Thu Sep 12, 2013 4:54 pm

Here is a link to comments from my colleague Jared Kizer

http://www.multifactorworld.com/Lists/P ... spx?ID=134

Best wishes
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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Fri Sep 13, 2013 9:09 am

Was thinking about this a bit more and thought I would bring this point up

It has been well known now for at least two decades that no matter the value metric used, if you buy stocks with a low price to pretty much anything, you get a premium.
Did not matter if you bought stocks with low p/e, low p/d, low p/s, low p/cf, low p/b or whatever. There have now been many out of sample tests of this, both in terms of time and various markets. A low price strategy shows premiums.

Among the many metrics used is p/cf, and in fact it often has shown the highest premium.

Now p/cf is a gross profitability measure.

So portfolios formed based on p/cf produced large premiums.

BTM was used by many to build funds because it is more stable, lower turnover, lower implementation costs.

Best wishes
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Fri Sep 13, 2013 9:32 am

wbern wrote:We can wave our hands all we want about risk versus behavioral, science versus pseudoscience, data mining versus real signal, or phases of the moon.

Like the rest of us, I find all of that intellectually fascinating on some level; heck, some of us even make writing careers out of it.

But at the end of the day, DFA is an eminently pragmatic firm, and their process boils down to the following:

1) Look for anomalies.
2) Test the most promising ones they can find in other time periods and in other markets. Small and value passed those tests, and now, so does profitability.
3) Take an ex-ante flier on the ones that test out.

Bill
WB makes an excellent point here. As I was thinking about the risk associated with factor investing, I had a "duh" moment when I realized that a key feature of the risk (maybe all of the risk) is that the factor doesn't exist. That is, the ex post findings won't translate into ex ante results. Or, that it's just a random thing that may show up, then go away, perhaps show up and go away again, etc. -- which is probably fairly descriptive of what has happened with value and small, for example. The risk you take is the risk that the "anomaly" doesn't show up, or it doesn't show up with much significance during your investing horizon. You may have to hang on for a couple decades to find out; that requires a real act of faith, and you might well end up empty-handed for all your dedication. The "risk" really boils down to the fact you are making a bet on whether the "factor" really exists and will materialize during your lifetime, and you have to be willing to stick with that bet for a really long time for it to ever pay off (which it might not, of course). Maybe some bets are better than others, even though none of them is a sure thing going forward. Betting on beta has worked out pretty well over a long time period. Betting on small and value has worked out, more or less. Betting on profitability is a little more speculative. How many bets should we be making?
We don't know where we are, or where we're going -- but we're making good time.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 9:54 am

That is exactly it: the real risk is that the premium doesn't exist any more.

I bought my first tilted DFA funds in the early 90s, and for several years it sure looked like the premia had disappeared.

How many bets do you make? As many you can: exposure to the market, small, value, and profitability factors in the US, developed markets, and emerging markets. That's twelve bets, I suppose (actually, more if you consider the individual national exposures, or less, to the extent that the premia cross-correlate). Unless most of them don't pan out in the long run, you win.

Bill

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Re: Severe criticism of DFA's "profitability" factor researc

Post by matjen » Fri Sep 13, 2013 10:04 am

wbern wrote: How many bets do you make? As many you can: exposure to the market, small, value, and profitability factors in the US, developed markets, and emerging markets. That's twelve bets, I suppose (actually, more if you consider the individual national exposures, or less, to the extent that the premia cross-correlate). Unless most of them don't pan out in the long run, you win.

Bill
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Re: Severe criticism of DFA's "profitability" factor researc

Post by scone » Fri Sep 13, 2013 10:21 am

Well, I'm in. I bought AQR's QCELX for large value, and QSMLX for small value. I don't think they are likely to do any worse than other value funds, and they might do a little better. Even if the only benefit is to lose a little less in bear markets, that's a win. I don't know for a fact that this will work, but it seems like pretty good odds to me. It's all about uncertainty.

It's like, Pascal steps into a bar off Wall Street, and meets Heisenberg, who's sharing a White Russian with Schrodinger's cat... :wink:
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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Fri Sep 13, 2013 10:23 am

Richard, I'm not ignoring it. There are many ways one can look at profitability. The higher up you go on the income statement the less you can manipulate, and cash flow is about as good as get. And of course the market sets the price. So p/cf is good measure IMO. Now others have looked at the data and find that using some combination of metrics might work better. (AQR). Possible. Pretty smart guys there

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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Fri Sep 13, 2013 10:27 am

One point on Bill Bernstein's comments is that his percentile listings for DFA are that they are based on data that has lots of survivorship bias in it. Eliminate that and the rankings would be considerably higher.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by swaption » Fri Sep 13, 2013 11:24 am

wbern wrote:That is exactly it: the real risk is that the premium doesn't exist any more.

I bought my first tilted DFA funds in the early 90s, and for several years it sure looked like the premia had disappeared.

How many bets do you make? As many you can: exposure to the market, small, value, and profitability factors in the US, developed markets, and emerging markets. That's twelve bets, I suppose (actually, more if you consider the individual national exposures, or less, to the extent that the premia cross-correlate). Unless most of them don't pan out in the long run, you win.

Bill
Honestly, I don't really view the risk as the premia no longer existing. My concern is more related to an underlying tendency to not completely dismiss the risk arguments and embrace the systematic behavioral driven anomaly. I think the implication of this is that perhaps there are some set of risks not adequately captured by the last century. In this regard, no matter how compelling the strategy, there is this risk of the unknown. I say this in the context of my broader view that the manner that we collectively engage in this disintermediated, passive form of investing to a great extent anesthetizes investors from the real risks of equities. But maybe that's where the behavioral benefits are derived, being at a safe distance from the true nature of the risks we are collectively taking. But the bottom line is that for some/many (including myself), I think it's hard to view their market beating performance over an extended time frame as some sort of free lunch that does not involve some form of additional risk, the magnitude or nature of which is not at all clear.

All fun stuff to think about, which is all I really do. Have not made much in the way of material changes to my portfolio construction in over a decade. The profitability factor does look interesting. But honestly more tempted to manage a small portfolio using Greenblatt's filters or the stuff from the Quantitative Value book. Wouldn't mind just getting a bit closer to what is fundamentally going on.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Fri Sep 13, 2013 11:31 am

I say this in the context of my broader view that the manner that we collectively engage in this disintermediated, passive form of investing to a great extent anesthetizes investors from the real risks of equities
Strikes a chord. I've often thought of that myself. One favorite quote that reflects the detachment: "I can tolerate risk -- it's losing money that really bothers me." Not sure that we remember that risk is losing money, maybe permanently.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by matjen » Fri Sep 13, 2013 11:36 am

Browser wrote:
I say this in the context of my broader view that the manner that we collectively engage in this disintermediated, passive form of investing to a great extent anesthetizes investors from the real risks of equities
Strikes a chord. I've often thought of that myself. One favorite quote that reflects the detachment: "I can tolerate risk -- it's losing money that really bothers me." Not sure that we remember that risk is losing money, maybe permanently.

That is a great quote. Cuts to the bone.
A man is rich in proportion to the number of things he can afford to let alone.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Fri Sep 13, 2013 11:46 am

decided to change my signature.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 11:59 am

Without wanting to look like I'm pumping my little booklet, there are two risks to tilting:

1) Shallow risk. In the case of the factors, it showed up clearly enough in '08-'09, when the factors lost money. In Ilmanen's formulation, "bad returns in bad times." But that shallow risk reversed, and then some. (Same thing happened in '29-'32.)

2) Deep risk, in this case, that the factor has a negative long-term return. ("Long-term" meaning, say, the majority of your investing lifetime.)

Both should be compensated.

Bill

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Blue » Fri Sep 13, 2013 2:03 pm

wbern wrote:That is exactly it: the real risk is that the premium doesn't exist any more.

I bought my first tilted DFA funds in the early 90s, and for several years it sure looked like the premia had disappeared.

How many bets do you make? As many you can: exposure to the market, small, value, and profitability factors in the US, developed markets, and emerging markets. That's twelve bets, I suppose (actually, more if you consider the individual national exposures, or less, to the extent that the premia cross-correlate). Unless most of them don't pan out in the long run, you win.

Bill
Bill - I seem to recall you in another thread indicating profitability factor was more for institutions (required to hold large/small growth) and less for individuals? In this post you seem to be more embracing of the profitability factor for individuals?

Thanks for clarifying.
Blue

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 2:14 pm

No, I made that point about DFA's series of growth funds that grazed profitability. When I looked at the backtested series, I saw that they had returns that were nearly the same as the overall markets, so what was happening was that the profitability premium was offset by the "grotwh penalty." You have to ask "Why bother?"

The only answer to that question that makes sense is that DFA is aiming at institutions that are mandated to have growth portfolios.

Bill

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Re: Severe criticism of DFA's "profitability" factor researc

Post by SteveB3005 » Fri Sep 13, 2013 2:38 pm

" You have to ask "Why bother?"

This is where it always seems to end up with tilting , and especially in non-tax advantaged accounts, the after tax returns and risk adjusted gains of a TSM index are extremely hard to beat.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by richard » Fri Sep 13, 2013 2:51 pm

larryswedroe wrote:Richard, I'm not ignoring it. There are many ways one can look at profitability. The higher up you go on the income statement the less you can manipulate, and cash flow is about as good as get. And of course the market sets the price. So p/cf is good measure IMO. Now others have looked at the data and find that using some combination of metrics might work better. (AQR). Possible. Pretty smart guys there
p/cf is a much more sensible metric than Novy-Marx's profitability, at least if you care about accounting manipulation issues.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 2:52 pm

No, in this case, the "why bother" refers to starting with a growth portfolio, then adding profitability.

Tilting, particularly in the large value space, can be done tax efficiently, as demonstrated by the DFA tax managed large value funds and Vanguard's tax managed small cap fund, in a reasonably tax efficient manner.

Bill
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Re: Severe criticism of DFA's "profitability" factor researc

Post by richard » Fri Sep 13, 2013 2:56 pm

wbern wrote:Without wanting to look like I'm pumping my little booklet, there are two risks to tilting:

1) Shallow risk. In the case of the factors, it showed up clearly enough in '08-'09, when the factors lost money. In Ilmanen's formulation, "bad returns in bad times." But that shallow risk reversed, and then some. (Same thing happened in '29-'32.)

2) Deep risk, in this case, that the factor has a negative long-term return. ("Long-term" meaning, say, the majority of your investing lifetime.)

Both should be compensated.
Bill,

Every investment strategy runs the risk of losing money over any given short term or long term. Does that mean they all should be compensated for taking the risk?

Perhaps I'm not understanding your post.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 2:59 pm

Perhaps I should have added the qualifier "systematic" before each of the risk names!

Bill

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Re: Severe criticism of DFA's "profitability" factor researc

Post by SteveB3005 » Fri Sep 13, 2013 3:08 pm

I'm sure there are cases where that's true, but with Vanguard I don't see it.



Tax-adjusted Return .........5yr..10yr..15yr Morningstar*


VTSMX Vang TSM............. 7.37 7.39 5.92

VIVAX Vang LgV Indx .........6.32 7.04 5.38

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Re: Severe criticism of DFA's "profitability" factor researc

Post by richard » Fri Sep 13, 2013 3:11 pm

I might be reacting more to your earlier post: "the real risk is that the premium doesn't exist any more." That's true of anything. The real risk should be some economic story (or some would say behavioral story) beyond the existence (or persistence) of the alleged risk factor.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 3:15 pm

VIVAX sure isn't tax managed, and it's very weak tea value wise.

On the Vanguard side, I was referring to small loading: at 10 years, the returns for VTMSX and VTSMX are 10.42/7.94, and I don't recall VTMSX ever having a cap gains distrib, plus, its dividend distribs are much smaller than VTSMX's.

Bill

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Bill on why bother

Post by larryswedroe » Fri Sep 13, 2013 3:17 pm

To address Bill's point --his "guess" is exactly right. They developed the funds for those that want to "fill the style boxes" which are mostly institutional investors. Since they don't have a "growth" fund they created it to fill the box.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Fri Sep 13, 2013 3:20 pm

Richard
I'll just add this, that with the metrics used by AQR and DFA the data shows persistent premiums across markets and asset classes. Luck, coincidence? You obviously will make your own decision
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Fri Sep 13, 2013 6:00 pm

larryswedroe wrote:Richard
I'll just add this, that with the metrics used by AQR and DFA the data shows persistent premiums across markets and asset classes. Luck, coincidence? You obviously will make your own decision
Best wishes
Larry
So then, is AQR the best way to get at profitability for those who don't have access to DFA?
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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Fri Sep 13, 2013 6:54 pm

Browser, don't know what else is out there but having seen in detail the AQR approach I certainly think it's a good one and my firm has approved it for use with institutional clients
Larry

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Re: Severe criticism of DFA's "profitability" factor researc

Post by medesess » Fri Sep 13, 2013 7:16 pm

Bill, I think DFA is a good company that has had good performance for the reasons I mentioned in my article. I wish it weren't DFA I was calling out about this. But read the sequence of papers I cited from their Quarterly Institutional Review. It's scientism. Fama and French make the unique argument that if you've got a three-variable formula in a, b, and c and a increases with b if you hold c constant, then you can conclude that a increases with b if you don't hold c constant. That's their "motivation" for inferring that expected return increases with profitability. It's even contradicted by Fama's own efficient market assumption, if he's still an adherent, which would say that if the earnings stream goes up then price must go up to keep expected return constant. The sequel in the DFA papers then enshrines this "result" as "financial economics" and goes on to use it to transform a historical return premium into an expected one - I.e. a theoretical one.

You and Browser have the right attitude toward science in finance. So why do I think it's important to nip the sort of scientism that DFA is now displaying (they didn't used to) in the bud? First, because the supposed mathematical sophistication of the field - which is as nothing compared with virtually any field of science or engineering, and is often plain wrong - is used to intimidate people into paying exorbitant amounts for worthless investment products, not to mention
it was an excuse for firms to substitute "sophisticated" risk models for good judgment prior to the financial crisis (and they still do). Second because it doesn't meet academic standards, yet when it's published in academic journals of finance (as this recent Fama/French will be, or would have been if I hadn't called attention to it) it becomes an object of worship as if it were Einsteinian. You are more easygoing about it and perhaps that is good, but I think this is a big problem.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Bill Bernstein » Fri Sep 13, 2013 8:13 pm

Well, in the first place, finance is properly defined as a "social science," the practical meaning of which is that, like other social sciences, the systems are mutable, and do not behave as reproducably as airfoils or electrical circuits. But still, hypotheses are formulated, models are built, then are tested, and Fama and French certainly did that. And it's not like F/F haven't been looking at profitability and returns for a long time, see, for example, their 2006 paper in JFE, “Profitability, Investment, and Average Returns.”

Does DFA lay on their "scientific approach" and "Nobel Prize winning research" a bit thick? Sure, they do, but if you're going to apply that standard, then Vanguard is an even worse violator. In fact, the only major money manager I know of who never spent a dime on advertising or marketed himself at all was Michael Price at Mutual Series, bless his soul.

It's important, too, to separate DFA from Gene and Ken, who are anything if not intellectually rigorous and open minded about their formulations. Gene was researching the momentum factor when many of his worst critics were in short pants, and he describes it as a major violation of market efficiency; of late both he and Ken have admitted that there's likely a partially behavioral basis to the value premium.

I haven't asked him how he feels about profitability and the EMH, but I wouldn't be surprised if he didn't think that the two were perfectly congruent. I think it's likely that the relatively minor portfolio tweaking DFA will be doing--essentially screening out a relatively thin crust of the least profitable firms--will be beneficial. Am I sure it will work? No, and if I were, it wouldn't be a risk premium.

Bill

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Fri Sep 13, 2013 10:24 pm

I know this is a wild exaggeration, but restates my previous comment that the "factor models" and "smart beta formulations" seem to be morphing into somewhat unmanageable proportions for us average folks. First, if we could expect to keep reaping that historical 8% real annualized return from equities, I think we'd all be happy just to buy the S&P and let it go at that. But since that doesn't seem to be in the cards anymore, the hunt is on for more exotic strategies to try to squeeze more juice out of tired old Mr. Market. Second, I couldn't help thinking of Dr. Oz. He keeps digging up more and more vitally significant dietary entities, potions, and supplements with every show, and I can't help but wonder just how to manage taking all this stuff, or how to narrow it down to just a few dozen or so. Beta, Small, Value, MOM, Profitability, Domestic, Developed, Emerging. Yikes! I'm just glad Dr. Oz isn't a financial economist -- it could be worse. :wink:
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Re: Severe criticism of DFA's "profitability" factor researc

Post by bertilak » Fri Sep 13, 2013 11:14 pm

Browser wrote:I know this is a wild exaggeration, but restates my previous comment that the "factor models" and "smart beta formulations" seem to be morphing into somewhat unmanageable proportions for us average folks. First, if we could expect to keep reaping that historical 8% real annualized return from equities, I think we'd all be happy just to buy the S&P and let it go at that. But since that doesn't seem to be in the cards anymore, the hunt is on for more exotic strategies to try to squeeze more juice out of tired old Mr. Market. Second, I couldn't help thinking of Dr. Oz. He keeps digging up more and more vitally significant dietary entities, potions, and supplements with every show, and I can't help but wonder just how to manage taking all this stuff, or how to narrow it down to just a few dozen or so. Beta, Small, Value, MOM, Profitability, Domestic, Developed, Emerging. Yikes! I'm just glad Dr. Oz isn't a financial economist -- it could be worse. :wink:
I put it all in Wellington and Wellesely and let the Wellington Management Group sort it all out. As far as I can tell they have been doing a pretty good job so far.

Life is much simpler this way. :beer
May neither drought nor rain nor blizzard disturb the joy juice in your gizzard. -- Squire Omar Barker, the Cowboy Poet

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Re: Severe criticism of DFA's "profitability" factor researc

Post by medesess » Fri Sep 13, 2013 11:19 pm

Browser, that's my next book! It will do exactly that -- can I quote you?

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Re: Severe criticism of DFA's "profitability" factor researc

Post by YDNAL » Sat Sep 14, 2013 5:30 am

Browser wrote:I know this is a wild exaggeration, but restates my previous comment that the "factor models" and "smart beta formulations" seem to be morphing into somewhat unmanageable proportions for us average folks. First, if we could expect to keep reaping that historical 8% real annualized return from equities, I think we'd all be happy just to buy the S&P and let it go at that. But since that doesn't seem to be in the cards anymore, the hunt is on for more exotic strategies to try to squeeze more juice out of tired old Mr. Market. Second, I couldn't help thinking of Dr. Oz. He keeps digging up more and more vitally significant dietary entities, potions, and supplements with every show, and I can't help but wonder just how to manage taking all this stuff, or how to narrow it down to just a few dozen or so. Beta, Small, Value, MOM, Profitability, Domestic, Developed, Emerging. Yikes! I'm just glad Dr. Oz isn't a financial economist -- it could be worse. :wink:
At the end of the story, savings rate becomes KING. Long live the KING !
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Re: Severe criticism of DFA's "profitability" factor researc

Post by matjen » Sat Sep 14, 2013 6:54 am

Browser wrote: "I can't help but wonder just how to manage taking all this stuff, or how to narrow it down to just a few dozen or so. Beta, Small, Value, MOM, Profitability, Domestic, Developed, Emerging. Yikes!"

The Doctor is in. ;-) My equity prescription is let AQR or DFA or similar figure it out*:
50% US Core Equity 2 Portfolio (DFQTX)...or Vector (or perhaps a mix)
30% International Core Equity Portfolio DFIEX)...or Vector (or perhaps a mix)
10% Emerging Markets Core Portfolio (DFCEX)
10% DFA Global Real Estate Securities I (DFGEX)

YDNAL wrote: "At the end of the story, savings rate becomes KING. Long live the KING !"

As the youngsters used to say....WORD!!!!!!!

*EDIT: Though VTI and VXUS are my two largest holdings.
Last edited by matjen on Sat Sep 14, 2013 8:19 am, edited 1 time in total.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Sat Sep 14, 2013 7:32 am

BTW-nothing really new here. For those interested in the "state of the art" should read Antti Illmanen's outstanding book on Expected Returns

The literature has moved to diversifying sources of returns, and it's been shown that diversifying across them produces more efficient portfolios as the factors generally have low correlations (otherwise they would not be unique).

Another good book for those interested is Successful Investing is a Process http://www.amazon.com/Successful-Invest ... 1118459903 which I am just finishing this weekend. Some really good stuff on taxes, asset location, portfolio construction, rebalancing and so on.

Larry

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Robert T » Sat Sep 14, 2013 1:00 pm

.
Some of my initial views on the profitability premium.

1. There is a “profitability premium” as defined by Novy-Marx :
  • Averaging 0.34% per month from July 1963-Dec 2012 (using PmU series on Novy-Marx’s website). Slightly smaller that the value premium of 0.37% per month over this same period.
2. There seems to be inconsistencies between the way DFA describe it and the data:
  • The way the profitability dimension is described in the DFA matrix booklet is: “Expected returns = expected cash flow/price. Higher expected returns are the result of having either higher expected cash flows or a lower price. The direct profitability dimension is tied to the numerator and the relative price dimension to the denominator. Stated another way, if two stocks sell at the same price, then the one with higher expected cash flows must have a higher expected return. These two dimensions, relative price and direct profitability can be combined to improve portfolio structure.” http://www.ifa.com/pdf/DFA/matrix_book_us_2013.pdf

    This seems to imply that a portfolio constructed by Cashflow-to-price (CF/P) should have a positive load to value and profitability. Fortunately Ken French has a portfolio formed by CF/P (sorted by 30% highest). From 1963-2012 this portfolio had a positive and significant value load, but it had a negative and significant profitability load when used alone or with Mkt, Size, and Value (using Novy-Marx’s PmU series from his website) – the opposite of what the DFA booklet seems to imply for the profitability load (if my understanding is correct).
3. Data or theory driven?
  • The Novy-Marx paper seemed to be answering a question of do firms with high profitability have higher returns than firms with low profitability, rather than starting with a theoretical model of the reasons that this should be the case then testing this hypothesis. In my view, each approach has their place, each with their own limitations. I think it is fine to ‘let the data speak’ (aka Sims) and then try to understand what it is saying. Obviously there needs to be some guidance from theory on the starting point (e.g. economic variables).
4. Real risk or an anomaly that will be arbed away?
  • My take on the mkt, size, and value premiums is that they are risk based stories – and using wbern’s categorization – both shallow risk (’29-32 and 08-09 - bad returns in bad times), and deep risk (risk of negative long-term returns - http://www.dfaus.com/pdf/Volatility_And_Premiums.pdf). I think there is also a risk story in the profitability premium – but it seems shows up at a different time to size and value risk, but often at same time as market risk.

    From May 1972 to May 1977 the average equity premium (Mkt-rf) was -0.29% per month, while the average profitability premium was -0.91%, or put another way the cumulative market returns (Mkt) over this period was about 2%, while for a portfolio with a 0.5 ‘profitability’ load it would have been -24%, a period when cumulative inflation was 45%. So highly profitable firms seem to do poorly in high inflation periods (perhaps due to lower leverage/debt) relative to less profitable firms (as debt burdens are reduced by inflation). To me – this is risk (particularly in distribution phase). [the linked paper provides some characteristics of firms with high 'profitability' compared to those with low 'profitability - http://users.cla.umn.edu/~jianfeng/ROA.pdf ]
5. What’s an individual investor to do?
  • In my earlier assessments – S&P 600 value, RAFI, and Bridgeway already capture some of the profitability premium (through the financial screens of S&P, the ‘profitability’ sorts of RAFI, and the avoidance of firms on the way to bankruptcy by Bridgeway). Exposure to the ‘profitability’ premium seems better in accumulation phase, than distribution phase (given the risk of poor performance in high inflation periods).
Robert
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Browser » Sat Sep 14, 2013 5:34 pm

Robert T. -- Thanks for that amazing analysis. :thumbsup
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Re: Severe criticism of DFA's "profitability" factor researc

Post by Robert T » Sat Sep 28, 2013 3:06 pm

.
A bit more analysis on the profitability factor (at least my take/due diligence)

1. High quality stocks = “defensive stocks” (more or less).
  • Defensive stocks include consumer staples, healthcare, and utilities – i.e. those expenditure items households are least likely to cut back on in times of economic distress (more inelastic demand than other sectors).

    AQR’s defensive equity fund overweights consumer staples, healthcare and utilities (the only sectors it overweights relative to the Russell 1000) which is the result of a stock selection criteria based on “lower beta stocks of companies with stable businesses, high profitability, low operating and financial leverage, lower earnings-per-share variability and other measures of quality”

    GMO’s quality fund overweights consumer staples and healthcare (together accounting for about 60% of current portfolio holdings – almost 3 times the share of the S&P500) which is the result of a stock selection criteria the “consider several factors, including, in particular, high profitability, stable profitability, and low leverage.” The GMO quality fund has a ‘profitability load of 0.23 (based on analysis of data from Feb 2004-Dec 2012).
2. Adding consumer staples to a value tilted portfolio can add a profitability load (without significant reductions to a portfolio value load).
  • Using the “10 industry portfolio” on the Ken French website, consumer staples (consumer non-durables) has a large profitability load of 0.46 and a positive value load of 0.29 (using Novy-Marx’s PmU data for the profitability factor from July 1963 to December 2012). Healthcare also has a positive and significant profitability load of 0.35, but it has both a negative size and value load, both about -0.2. While utilities had low beta (0.65) perhaps qualifying them for the AQR portfolio, they had a negative ‘profitability load’, perhaps the reason for their exclusion in the GMO portfolio.

    Code: Select all

    Factor loads
    
    Consumer non-Durables (consumer staples): July  1963 – December 2012
    
    Alpha (t-stat)  Mkt   Size  Value  Profitability (t-stat)
     0.01   (0.08)  0.85  -0.05   0.29        0.46 (11.2)

    Adding consumer staples (e.g. through the Vanguard Consumer Staples etf) to a value tilted portfolio could add a profitability load without significant cost to the overall portfolio’s value load. The Vanguard consumer staples ETF tracks the MSCI consumer staples ETF and from 1992-2012 (for which data are available) it gives similar results to Ken French’s ‘Consumer non-durables’ series over the same time period (i.e. positive and significant profitability and value loads and similar orders of magnitude).
3. A higher profitability load may add more downside protection in financial crises and deflation, but it reduces downside protection in inflationary periods
  • I constructed two stock-bond portfolios with the same expected return, the first with only a size and value tilt in the equity allocation, and the second with a size, value, and profitability tilt. Five year government bonds were added for the bond allocations (results are similar with t-bills). Assumptions for the long-term size, value, and profitability premium were 2, 4, and 3 percent. The equity allocation in the first portfolio had a 0.2 and 0.4 size and value load, the second portfolio had a 0.15, 0.35, and 0.10, size, value and profitability load respectively (the second portfolio tilts were derived by simply adding to the first portfolio a 20% allocation to consumer staple [consumer non-durables]). The first portfolio was 75:25 stocks:bonds, the second was 77:23, to account for the lower beta from the addition of consumer staples. Here are some of the results.

    1979-2012. Similar to the DFA results, the portfolio with more exposure to ‘profitable companies/stocks’ had higher annualized return (0.3 difference, compared to the 0.4-0.6% difference in the article), and with lower standard deviation. The 2008 returns were -23.4% (without profitability) and -22.6 (with profitability).

    Annualized return: 1979-2012 (Standard deviation)

    Without profitability tilt.…….12.7 (12.8)
    With profitability tilt….……….13.0 (12.5)

    1927-2012: The return difference disappears, but the portfolio with a greater tilt to profitable companies/stocks still had lower standard deviation. If we look at the three periods of significant negative returns (looking at real (inflation adjusted) returns) then adding profitability improved performance in 1929-32 and 2008, but worsened performance in 1973-74.

    Annualized return: 1927-2012 (Standard deviation)

    Without profitability tilt.…….11.1 (17.4)
    With profitability tilt….……….11.1 (16.8)

    Code: Select all

    Real (inflation-adjusted) returns.
    
                                   1929-32  1973-74   2008
    Without profitability tilt      -45.9    -47.1   -23.6     
    With profitability tilt         -42.0    -49.2   -22.7
    The greater the expected returns of a portfolio that comes from a greater tilt to ‘profitable’ companies/stocks, the greater the expected protection in deflationary periods (1929-32) and financial crises (2008), and less expected protection in inflationary periods (1973-74).
4. Longer duration and lower debt levels of high quality stocks lead to relatively poorer performance in periods of high (unexpected) inflation.
  • Longer duration: Consumer staples (consumer non-durables), healthcare and utilities were the only portfolios of the ’10 industry’ portfolios that had a positive and significant term load. This suggests these stocks have longer duration (perhaps from more stability in the businesses), and are more negatively affected by unexpected inflation, as are longer-term bonds.

    Lower debt levels: Higher quality stocks tend to have lower debt levels. For example the stocks in the GMO Quality fund have a debt/equity ratio (weighted median) of 0.6, while the ratio for stocks in the S&P500 is 0.9. As unexpected inflation reduced the real cost of debt it benefits ‘low quality stocks’ more than ‘high quality stocks’.
5. Does adding more exposure to higher quality stocks (a higher profitability load) add value to a small cap and value tilted portfolio?
  • I think it depends on which risks we are concerned more about – unexpected inflation, or deflation and financial crises. If I read Bill Bernstein’s book on Deep Risk correctly – then an inflation shock is the most likely deep risk we face. In this respect I am not so convinced that adding a profitability tilt is such a good thing to do to an already small cap and value tilted portfolio, particularly if it comes at the expense of lowering the value tilt.
Based on this analysis, I am happy to stay the course with my globally diversified small cap and value tilted portfolio (don’t see a real need to try to add more exposure to ‘profitable companies/stocks’), but will continue to read future research that comes out on this topic to see if any of the above analysis needs revision.

Robert
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Re: Severe criticism of DFA's "profitability" factor researc

Post by berntson » Sat Sep 28, 2013 3:26 pm

Thanks Robert! I found your thoughts really helpful.

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Re: Severe criticism of DFA's "profitability" factor researc

Post by larryswedroe » Sat Sep 28, 2013 3:58 pm

Robert
That's good work and very logical outcomes
My only comments are that adding profitability increases the reliability of the above market performance and reduces TE which is a real risk for at least some people
Larry

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Re: Severe criticism of DFA's "profitability" factor researc

Post by matjen » Sat Sep 28, 2013 5:07 pm

Robert thank you for your contributions to this forum. Really wonderful stuff. :sharebeer
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Re: Severe criticism of DFA's "profitability" factor researc

Post by lazyday » Thu Jan 01, 2015 8:20 am

Robert T wrote:Longer duration and lower debt levels of high quality stocks lead to relatively poorer performance in periods of high (unexpected) inflation.
Is the empirical evidence convincing? I don't know if the Nifty Fifty whipsawed Quality in the early 70s period.

The theories on long duration and low debt seem to make sense.

A contrasting theory is that Quality companies don't need much capital investment, and generate lots of cash, so are protected against inflation.
http://www.bogleheads.org/forum/viewtop ... 49#p825549

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Re: Severe criticism of DFA's "profitability" factor researc

Post by Robert T » Thu Jan 01, 2015 10:27 am

lazyday wrote:
Robert T wrote:Longer duration and lower debt levels of high quality stocks lead to relatively poorer performance in periods of high (unexpected) inflation.
Is the empirical evidence convincing? I don't know if the Nifty Fifty whipsawed Quality in the early 70s period.

The theories on long duration and low debt seem to make sense.

A contrasting theory is that Quality companies don't need much capital investment, and generate lots of cash, so are protected against inflation.
http://www.bogleheads.org/forum/viewtop ... 49#p825549
Here is some empirical evidence:

Novy-Marx Quality (Profitable-minus-Unprofitable factor - PMU)
PMU
1973 = -24.1%
1974 = -10.1%

Fama French (Robust operating profitability minus weak operating profitability - RMW)
RMW
1973 = -9.5%
1974 = -3.9%

In contrast to value ("value companies" tend to have higher debt levels)
HML
1973 = +18.2%
1974 = +10.0%

'Value' tilts tend to provide greater protection to unexpected inflation than 'quality' tilts.

Robert

PS. Would just note that the definition of 'quality' varies significantly (more so than value). For example Asness's Quality minus Junk (QmJ) has a relatively low correlation with Novy-Marx's PMU factor. QMJ had less real downside in 1973-74. Wider variation in the definition of a factor makes me somewhat cautious on the robustness of "Quality" as a separate factor.
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Re: Severe criticism of DFA's "profitability" factor researc

Post by lazyday » Thu Jan 01, 2015 10:58 am

For example Asness's Quality minus Junk (QmJ) has a relatively low correlation with Novy-Marx's PMU factor.
And I'm assuming Quality/Profitability is correlated with both high earnings and low capex, maybe not as true as I think.
Here is some empirical evidence:
I'm a little wary of the 70s time period for Quality, like I'd be worried about looking to the 2000-2001 time period for largecap growth.

According to the second page of http://www.aaii.com/journal/article/val ... ifty-fifty in 1972 the Nifty Fifty had PE 41.9 vs S&P 500 18.9.

It seems some call the N50 growth stocks, others talk about stability and increasing dividends over time. Both of the latter are often associated with Quality, and a look at the list on the page above or on wikipedia shows many obvious Quality companies, including consumer staples and healthcare.

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