The line between Active vs Passive is blurring: When does chasing risk factors end?

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AndroAsc
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The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

As a Boglehead investor, I keep to my plan, stay the course, etc... That means I also don't follow very closely the latest developments in the "investment" world. The last time I constructed my asset allocation was 10 years ago, and it's pretty much the same as it was, except for the inclusion of foreign REITs, but that was because we didn't have a good fund for that.

As I read up on the latest development in the "investment" world, I find that the line between passive vs active investments are blurring. I would make a distinction that I am a passive investor and not a purist index investor. Don't crucify me.

Here are increasing levels of passive investing "sophistication" that I have pieced together.

Level 0
Pure index investor. Purchases US total market index fund and International total market index fund.

Level 1
Additional asset classes are added here, usually based on the historical data that they don't correlate perfectly with the broad market returns. Examples include REITs and commodities. Some like commodities still remain highly controversial, as to whether they add any true diversification value.

Small-value tilting is also introduced here. SV tilt is based on decades of academic research, and its implementation is straightforward, in the sense that small and value can be clearly defined. I know a lot of Bogleheads on this board do SV tilt, with the "promise" that our returns at the end of the day, e.g. >30 years later, will be higher, but with greater risk/volatility during the course.

This is where I am right now, I do SV tilt, with dedicated allocation to REITs and commodities.

Level 2
Newer risk factors, namely momentum is being incorporated here. Momentum is characterized by funds that are "on the uptrend" and seems to be straightforward enough passive rule to follow. Granted, this has only been "made possible" through AQR, so it's not possible to have this in an investment plan 10 years ago. After much searching on the forums I realize they are now open to normal investors via TD Ameritrade. With ~5+ years track record, it remains to be seen if a momentum-tilted portfolio implementation will have returns that exceed the added costs, especially since we are talking about a 20-30 year time horizon. Read several papers on how momentum is anti-correlated to value, making a momentum-value tilted portfolio a potent combo. Major issues seems to be cost and taxes, since there is considerable turnover. However, the added returns from momentum *may* be worth the extra costs. I suppose time will tell. I am considering moving to this level.

Level 3
This came up after much reading into AQR products. Risk factors galore! Now besides small, value and momentum, I learn there is profitability. Will this never end? As much as I support academic/research-backed passive strategies, I'm thinking this is going a bit too far. Oh... and now AQR has a multi-style fund that automatically adjusts into whichever risk factor that is overperforming for the time period (e.g. QCELX - AQR Large Cap Multi-Style Fund). I guess I am not comfortable with this, because with SV-tilting and maybe even Momentum tilting, I can see myself doing this stock screening on my own and running my own fund, after all it's just running the numbers and applying a formula. But now, funds like QCELX becomes a "black box" and we don't know how these fund managers allocate/choose between various risk factors. How is this any different, especially in the "philosophical approach" from Technical Analysis and Fundamental Analysis? It seems to be hand waving here.

Finally, we have QSPIX - AQR Style Premia Alternative Fund, from a recent prominent thread here, which to be honest looks like what a hedge fund is. I'm not rich enough to own hedge funds, but I know those are sophisticated sounding products with the intention to suck money out of the rich and foolish. QSPIX now adds 2 more risk factors - Carry and Defensive, and dynamically allocates the fund across not only equities, but now commodities and currencies as well! Great, an all purpose "magic pill" fund.

After reading my "Level 3" passive investment strategy... how does it not sound like active management? Sure, they may use established methods to calculate various risk factors, but changing styles, asset classes at the discretion of the fund manager... isn't that active management? Where do you draw the line, and say all this added academic research is really bullshit and nothing but an attempt to milk us with fees? Admittedly, I am still reading up on these new AQR funds, and I may be jumping the gun in my statements, so I welcome comments from AQR proponents.

To play devil's advocate, many of the investment strategies in "Level 2" and above have only been made possible with recent fund offerings. So, it's not really the matter of "staying-the-course" since you would not have considered these products 10 years ago. Truthfully, it's possible that AQR may be able to capture momentum, and a momentum-value strategy will outperform a purist index strategy by 2% annualized returns after fees over the next 30 years. But, it's a chicken-and-egg scenario, because we won't know if this will be possible, and if there is sufficient evidence to show that it is, I'll probably be retired by then. Don't forget that SV tilt had about 20+ years of past performance in actual mutual funds to show it is "plausible".

My question, and also to stimulate some discussion is
1) Where do you stand on the various "levels" of increasingly sophisticated passive investment strategies?
2) At what point, do you call BS, and say this is really a form of active investing?
Last edited by AndroAsc on Mon Aug 10, 2015 10:12 pm, edited 2 times in total.
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Taylor Larimore
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by Taylor Larimore »

AndroAsc:

You have the "Levels" backward.
Albert Einstein: "The five ascending levels of intellect are: smart, intelligent, brilliant, genius, simple."
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exeunt
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by exeunt »

It's active investing as soon as you start adding tilts. That's why they're called tilts! Adding REITs is an active decision. So is favoring U.S. stocks over international stocks. Any portfolio that deviates from the global market portfolio is macro-inconsistent--meaning each dollar overweight must be matched by a dollar underweight. That is not to say these are bad decisions. The beauty of passive investing is not because it is pure and macro-consistent, it is because it's cheap and tax-efficient.

Now, I know Larry calls QSPIX a "passive" fund. But if your definition of passive encompasses a high-turnover, leveraged, long-short, multi-asset strategy, your definition is useless. QSPIX may be a fine fund (in fact, I think it's a great fund), but it ain't passive by any reasonable definition.
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by AndroAsc »

I guess we have a slight disagreement in terminology.

What you describe as "passive" is actually "index", or purist index.

A passive fund would be one that uses methodical, reproducible calculations, with zero or minimal "human" input. This means that I can be the fund manager, as long as someone teaches me how to use the algorithm that controls the fund. That describes DFA fund, they start with an index fund, and apply a value tilt to all their products. This is very different from an active fund, where the fund manager does whatever he wants based on his intuition or "experience".
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by Taylor Larimore »

The line between Active vs Passive is blurring:
Gus Sauter, retired Vanguard Chief Investment Officer: "There is one, and only one investment that is not active–-a total market portfolio–-one that provides the market beta. Everything else is active."
Best wishes.
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by exeunt »

All DFA is doing is using a simple quantitative trading strategy that focuses on stocks with low P/B and not too much negative momentum (OK, they did recently add a profitably signal). It may be systematic, it may require no human input, but it is still at heart a quantitative trading strategy. In fact, before DFA came out with it, quant funds were using value signals to generate trades.

By your definition, the RAFI funds are "passive." So are equal-weight, dividend-weighted indexes, and pretty much every smart beta ETF. When Bill Sharpe talks about the arithmetic of active investment, which is commonly cited as the best argument for passive investing, he defines passive investing as thus: "A passive investor always holds every security from the market, with each represented in the same manner as in the market." If he didn't, the arithmetic of active management is no longer guaranteed.

Even DFA defines their funds as "active." They do not call themselves passive investors. The notion that "passive" investing is simply systematic security selection with no market forecasting is a fairly recent invention that has little bearing on the academic definitions of active v. passive. Passive investing to academics is market-weighted investing and is macro-consistent. Active investing is anything that deviates from market cap weighting and is macro-inconsistent.
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AndroAsc
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

While I appreciate the whole terminology discussion, perhaps we could move on to the real topic for this post, which is when do these risk factor chasing strategies becomes no better than your typical active fund?
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by nedsaid »

AndroAsc wrote:While I appreciate the whole terminology discussion, perhaps we could move on to the real topic for this post, which is when do these risk factor chasing strategies becomes no better than your typical active fund?
Active managers have known about the factors for many years. Thus you have "Growth" funds, "Value" funds, "Small-Cap", and "Momentum" funds. Factor investing as practiced by DFA and AQR is in a middle ground between active and passive investing. It really is a form of active management with many more stocks, much less turnover, and much lower expenses.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by exeunt »

AndroAsc wrote:While I appreciate the whole terminology discussion, perhaps we could move on to the real topic for this post, which is when do these risk factor chasing strategies becomes no better than your typical active fund?
Um, this entire thread is a terminology discussion. Your query: When is a factor strategy active? The answer: When it's a factor strategy. When is it bad? Answer: When it becomes too expensive. The only reason why it's so confusing is because you're using a weird definition of passive.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

exeunt wrote:
AndroAsc wrote:While I appreciate the whole terminology discussion, perhaps we could move on to the real topic for this post, which is when do these risk factor chasing strategies becomes no better than your typical active fund?
Um, this entire thread is a terminology discussion. Your query: When is a factor strategy active? The answer: When it's a factor strategy. When is it bad? Answer: When it becomes too expensive. The only reason why it's so confusing is because you're using a weird definition of passive.
Seriously, if you have nothing positive to contribute, I think it would be better for you not to contribute at all. My definition of passive investing come from articles I read about DFA years back.

Even the wiki's entry on DFA says: http://www.bogleheads.org/wiki/Dimensio ... d_Advisors
"Dimensional Fund Advisors (DFA) is a mutual fund company located in Austin, Texas. The fund company is of particular interest to Bogleheads because of a corporate culture that is strongly tied to passive investing. "

Wiki's definition of passive management: https://en.wikipedia.org/wiki/Passive_management
Passive management (also called passive investing) is a financial strategy in which an investor (or a fund manager) invests in accordance with a pre-determined strategy that doesn't entail any forecasting (e.g., any use of market timing or stock picking would not qualify as passive management)

So DFA's value tilted index is a pre-determined strategy, and it's not forecasting anything. It is a passive investment. So a purist index investment strategy is a passive strategy, but not all passive strategies use pure index funds. If you have a problem with this definition, I really don't care, because that is not the point of this entire post!

The point of this post goes far beyond "cost matters" as well, again you seem to have a reading comprehension problem. The latest AQR funds are getting so "sophisticated" that it's like a "black box" to the retail investor. That's only a step away from your typical active fund, where the fund manager trades on "experience", "intuition" and "half-baked quantitative rationalization". The real question is where do we draw the line, and say, this AQR stuff (or the next academic-backed fund) is nonsense.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by lack_ey »

AndroAsc wrote:While I appreciate the whole terminology discussion, perhaps we could move on to the real topic for this post, which is when do these risk factor chasing strategies becomes no better than your typical active fund?
When the costs become comparable and the diversification down to the lower level of the typical active fund.

Factor investing is just another way to do stock picking. Usually, it's one where the investor is the manager calling the shots (the investor chooses which funds to use and selects them based on their rules; the manager just implements the rules), rather than deferring to a traditional active fund manager to do individual security selection.
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by kolea »

AndroAsc wrote:I guess we have a slight disagreement in terminology.

What you describe as "passive" is actually "index", or purist index.

A passive fund would be one that uses methodical, reproducible calculations, with zero or minimal "human" input. This means that I can be the fund manager, as long as someone teaches me how to use the algorithm that controls the fund. That describes DFA fund, they start with an index fund, and apply a value tilt to all their products. This is very different from an active fund, where the fund manager does whatever he wants based on his intuition or "experience".
William Sharpe's definition of passive investing is described in this paper: Passive Investing. Personally I think it is a good definition.

Basically, his definition is that there is only one passive portfolio: A cap-weighted set of stocks that represents the total market. Everything else is active, including funds that follow an index (other than the TSM index) as well as non-indexed funds (usually called active funds around here).

His assertion, which I find compelling, is that the average dollar invested cannot outperform the passive portfolio, even if those dollars are invested in an index fund (other than the TSM index). Note that he is not talking about the performance of a fund relative to TSM, only about dollars invested. This fact is often misquoted.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

As mentioned above, this is the only passive portfolio ... Overweighting stocks (such as a 60:40 portfolio) or skipping alternatives (Private Equity, real estate, emerging debt, hedge funds) is active investing

Image

And in principle the way to increase your return would be to use leverage (2 or 3x the market return is perfectly reasonable and straightforward)

I think it could also be argued that the true passive portfolio would have to have to include derivatives - but that would be quite difficult to calculate
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

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Active isn't inherently bad, so I don't see 'the line' as important. The problem with active is the expenses, and the inordinate risks some 'advisers' take. A broad market index ensures you're getting some 'average' consensus, and not paying any extra for it. There's plenty of 'active' mutual funds that do a good job of keeping expenses low and can reasonably expect 'average' returns. The problems start creeping in when the expectations are that somehow they're going to deliver 'above average'. We don't live in Lake Wobegone.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

One way I'd look at it - which I think you can see with the Larry portfolio, as well as the endowment model - is that there can be a happy medium between incurring slightly higher costs, and the only-"free-lunch"-in-town benefits of diversification

Vanguard Lifestrategy's portfolio may be an example of this, in that it doesn't just hold a global stock market and global bond fund, yet seems to achieve desirable long-term performance with more compartmentalisation

My own preference with stocks is to have high weightings in Micro-caps and Value - a) because smaller companies give you more domestic exposure (which gives you more diversification, when global large and mega-caps all tend to move together), and b) because value companies tend to be higher risk/higher return, I can ameliorate the added risk through higher diversification
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by rca1824 »

Maynard F. Speer wrote:As mentioned above, this is the only passive portfolio ... Overweighting stocks (such as a 60:40 portfolio) or skipping alternatives (Private Equity, real estate, emerging debt, hedge funds) is active investing

Image

And in principle the way to increase your return would be to use leverage (2 or 3x the market return is perfectly reasonable and straightforward)

I think it could also be argued that the true passive portfolio would have to have to include derivatives - but that would be quite difficult to calculate
If that data is true, if you only hold equities + government bonds + corporate bonds, you're holding 84.3% of the global market. That should be enough to approximate the outcomes of the global market. One could also add a slice of REITs to their portfolio and bring the total to 89.4%, but it doesn't seem strictly necessary. The fees on holding HY bonds and emerging market bonds seems too high to justify adding them, and their slices are so small that it wouldn't matter much anyway. In theory one could hold everything on here except private equity with simple Vanguard funds.

Where are commodities?

Also how do you square this strategy against a TIPS ladder strategy? TIPS only 2.3% of the global market but some people make TIPS a dominant slice (or the only slice) in their portfolio especially as they enter retirement. Why would a global cap weight portfolio be better than a TIPS ladder? Not everyone likes the associated risk of the global portfolio. Some may want more or less, and leverage isn't always readily available.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

Maynard F. Speer wrote:One way I'd look at it - which I think you can see with the Larry portfolio, as well as the endowment model - is that there can be a happy medium between incurring slightly higher costs, and the only-"free-lunch"-in-town benefits of diversification
The million dollar question really is what this "happy medium" is especially in the context of AQR new product offerings. Whenever a new product gets offered, based off substantial academic research, the question immediately pops to mind are:

1) Is this new risk factor/style the "real thing", i.e. is it not just an artifact from data mining?
2) If (1) is true, can we capture it in a practically efficient manner, i.e. is there a good chance that the extra expected returns make up for the extra fees?
3) If (2) is true, can the strategy be implemented in a robust manner that is "fund manager" independent - This is the line that separates the passive from the active world, because active fund returns are dependent on the fund manager (or so they claim) while passive are not. If you want to be specific, then we are talking about chasing alpha vs smart beta.
4) If (3) is true, is there anything that the fund is doing that might be taking more risks than a normal Boglehead would (e.g. derivatives, futures, etc...)

For SV tilt, criteria (1) to (4) are met to some degree, that's why I do it. I know my SV tilt portfolio has a reasonable chance of outperforming a non-tilt portfolio over my working lifetime, and I know my money will not go to zero because an SV tilt just modifies the index by screening it for small caps and value stocks, both of which are very "black and white" to understand and implement.

So back to the new AQR product offerings. How do we know that QSPIX will not go the way of LTCM? How do we know that QSPIX (or the AQR multi-factor fund) is the "real thing", and not just another LTCM?
Last edited by AndroAsc on Tue Aug 11, 2015 9:00 am, edited 1 time in total.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by nisiprius »

Maynard F. Speer wrote:As mentioned above, this is the only passive portfolio ... Overweighting stocks (such as a 60:40 portfolio) or skipping alternatives (Private Equity, real estate, emerging debt, hedge funds) is active investing

Image

And in principle the way to increase your return would be to use leverage (2 or 3x the market return is perfectly reasonable and straightforward)

I think it could also be argued that the true passive portfolio would have to have to include derivatives - but that would be quite difficult to calculate
I don't think this is true. The special characteristics of the market portfolio apply to "a market." If you have completely independent markets then I don't think there's any compelling reason to cap-weight the amount you invest in each. In real life no markets are completely independent--and no markets are completely integrated, either. The United States has, I dunno, one or two dozen stock markets at the moment, but the flow between them is so frictionless that I think it's reasonable to call it "a market."

The world has many different stock markets and the fact that they use different currencies means it is not one market... nor is it many completely independent markets... it's something in between.

I don't think there's any requirement that I invest in Thomas Kinkade, Painter of Light® paintings merely because some fraction of the world's dollars are invested in them--not if there isn't rapid flow and constant equilibration between the Thomas Kinkade market and the stock market.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

rca1824 wrote:If that data is true, if you only hold equities + government bonds + corporate bonds, you're holding 84.3% of the global market. That should be enough to approximate the outcomes of the global market. One could also add a slice of REITs to their portfolio and bring the total to 89.4%, but it doesn't seem strictly necessary. The fees on holding HY bonds and emerging market bonds seems too high to justify adding them, and their slices are so small that it wouldn't matter much anyway. In theory one could hold everything on here except private equity with simple Vanguard funds.

Where are commodities?

Also how do you square this strategy against a TIPS ladder strategy? TIPS only 2.3% of the global market but some people make TIPS a dominant slice (or the only slice) in their portfolio especially as they enter retirement. Why would a global cap weight portfolio be better than a TIPS ladder? Not everyone likes the associated risk of the global portfolio. Some may want more or less, and leverage isn't always readily available.
The real takeaway is that you'd not be holding a great deal in stocks .. The decision to hold 60% stocks is really a significant active bet on one particular asset class

Someone who believes in efficient markets *should* (I believe) leverage the risk up, rather than changing the weightings .. According to Shape, you can't get more efficient, so any tinkering is going to be to your detriment

Commodities only account for a small portion - there's another calculation here with commodities and hedge funds ... (And I think if I were going to follow a global market portfolio, I'd hold individual bonds, not bond funds)

Image
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by cottonseed1 »

JoMoney wrote:Active isn't inherently bad, so I don't see 'the line' as important. The problem with active is the expenses, and the inordinate risks some 'advisers' take. A broad market index ensures you're getting some 'average' consensus, and not paying any extra for it.
I completely agree. Debating over active vs passive is rather pointless. As JoMoney points out what matters is high cost vs low cost. If someone were to pay 1% or 1.5% for index funds they are going to get a disappointing result. Let's also image a world where index funds and active funds all have zero expenses. In this case, on average, active funds will have the same return as the market because as whole they are the market. Now of course if you have zero knowledge about selecting managers it would be dominated to select anything other than index funds as you get the same expected return without the possibility of investing in a sub-par manager.

I would also add that another problem with active management is the incentives for most "advisers" simply are not aligned with their customers. Not too surprisingly, the vast majority of advisers put their own interest first and of course their customers get a predictably bad result.
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by Ged »

Taylor Larimore wrote:AndroAsc:

You have the "Levels" backward.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

nisiprius wrote:I don't think this is true. The special characteristics of the market portfolio apply to "a market." If you have completely independent markets then I don't think there's any compelling reason to cap-weight the amount you invest in each. In real life no markets are completely independent--and no markets are completely integrated, either. The United States has, I dunno, one or two dozen stock markets at the moment, but the flow between them is so frictionless that I think it's reasonable to call it "a market."

The world has many different stock markets and the fact that they use different currencies means it is not one market... nor is it many completely independent markets... it's something in between.

I don't think there's any requirement that I invest in Thomas Kinkade, Painter of Light® paintings merely because some fraction of the world's dollars are invested in them--not if there isn't rapid flow and constant equilibration between the Thomas Kinkade market and the stock market.
Well that would be my opinion too .. I agree it's conceptually difficult to paint a real picture of a global market portfolio (derivatives, art, cars, etc), and I've never been convinced the world's many smaller markets can really be taken as a fluid whole

Then again, when I've looked into it, the risk-return characteristics of the global portfolio seem to make quite a good case .. and the idea of simply leveraging it up to the volatility of a 60:40, 80:20, or 110 portfolio, I think look quite compelling
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by AndroAsc »

cottonseed1 wrote:
JoMoney wrote:Active isn't inherently bad, so I don't see 'the line' as important. The problem with active is the expenses, and the inordinate risks some 'advisers' take. A broad market index ensures you're getting some 'average' consensus, and not paying any extra for it.
I completely agree. Debating over active vs passive is rather pointless. As JoMoney points out what matters is high cost vs low cost. If someone were to pay 1% or 1.5% for index funds they are going to get a disappointing result. Let's also image a world where index funds and active funds all have zero expenses. In this case, on average, active funds will have the same return as the market because as whole they are the market. Now of course if you have zero knowledge about selecting managers it would be dominated to select anything other than index funds as you get the same expected return without the possibility of investing in a sub-par manager.

I would also add that another problem with active management is the incentives for most "advisers" simply are not aligned with their customers. Not too surprisingly, the vast majority of advisers put their own interest first and of course their customers get a predictably bad result.
I disagree to some extent. I would rather have a 1% index fund than a 0.25% active fund (that is really active and not a closet indexer). Why? Because I know index fund will have minimal tracking error, whereas active funds frequently underperform their benchmarks even after including fees, because it's so dependent on the fund manager, weather, etc... and decades of research have shown that active management reduce returns even after factoring out the differences in fees.

The situation is no different with SV tilt using DFA funds for example, because it is still more "indexy" than active. I know their fund managers follow a select prescription of rules, and I know the performance is not dependent on the fund manager.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

AndroAsc wrote:
Maynard F. Speer wrote:One way I'd look at it - which I think you can see with the Larry portfolio, as well as the endowment model - is that there can be a happy medium between incurring slightly higher costs, and the only-"free-lunch"-in-town benefits of diversification
The million dollar question really is what this "happy medium" is especially in the context of AQR new product offerings. Whenever a new product gets offered, based off substantial academic research, the question immediately pops to mind are:

1) Is this new risk factor/style the "real thing", i.e. is it not just an artifact from data mining?
2) If (1) is true, can we capture it in a practically efficient manner, i.e. is there a good chance that the extra expected returns make up for the extra fees?
3) If (2) is true, can the strategy be implemented in a robust manner that is "fund manager" independent - This is the line that separates the passive from the active world, because active fund returns are dependent on the fund manager (or so they claim) while passive are not. If you want to be specific, then we are talking about chasing alpha vs smart beta.
4) If (3) is true, is there anything that the fund is doing that might be taking more risks than a normal Boglehead would (e.g. derivatives, futures, etc...)

For SV tilt, criteria (1) to (4) are met to some degree, that's why I do it. I know my SV tilt portfolio has a reasonable chance of outperforming a non-tilt portfolio over my working lifetime, and I know my money will not go to zero because an SV tilt just modifies the index by screening it for small caps and value stocks, both of which are very "black and white" to understand and implement.

So back to the new AQR product offerings. How do we know that QSPIX will not go the way of LTCM? How do we know that QSPIX (or the AQR multi-factor fund) is the "real thing", and not just another LTCM?
Diversification does seem to be a free lunch of sorts .. This is why I think the concept of "barbelling" (deviating from the middle of the market to offset higher risk against lower risk) may offer some mechanical advantages

Unfortunately AQR funds aren't easily available in the UK (otherwise I'd be very interested in QSPIX) .. But of course, making a decision to invest in a fund like that really does come down to your ability to assess its potential merits - so you can be wrong .. And then perhaps you're into the more active realm of having a process in place to minimise the impact of bad decisions, maximise the results of good ones

The more passive solution is perhaps to invest in an index of hedge funds - and the diversification benefits of doing so appear to show up on back-tests ... My own approach has been to build my own index of hedge-style funds (I hold 7, in three different categories) - and that way I can avoid an additional expense ratio, avoid anything with high fees (my average fee is about 0.8%), and can monitor performance and cut anything that starts to 'go wrong' ... My worry with more automatic/ETF-style alternatives is when they go wrong, they just tend to spiral into oblivion ... I've got limits on the amount of volatility I'd accept from a fund like this
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by cottonseed1 »

Maybe I am missing something obvious...

Assuming we are in backwards land where all active funds have 25 BP of total frictional cost (fees, taxes etc) and index funds have total frictional cost of 1% on average you would be better off in the active funds. Just as active managers as a whole cannot beat the market because they are the market, they cannot underperform it either. As a group it seems like a logical contradiction to assume that they can outperform or underperform when they make up the market.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by kolea »

AndroAsc wrote: 1) Is this new risk factor/style the "real thing", i.e. is it not just an artifact from data mining?
There is a phenomenon in physics called quantum fluctuations in which energy appears to be created spontaneously out of a vacuum, in violation of the law of conservation of energy. Quantum fluctuations are very real, until they are not.

I think that factors are "the real thing", until they are not. They have appeared to explain excess yields in the past but like quantum fluctuations they seem to violate market efficiency and should not exist. Here today but gone tomorrow? You really do not know and I doubt that anyone could know.

Personally it smells a little faddish to me. There have been many investing fads over the years, all of which worked until they didn't. Maybe you will catch this while it is working, or maybe not.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by rca1824 »

Maynard F. Speer wrote:
rca1824 wrote:If that data is true, if you only hold equities + government bonds + corporate bonds, you're holding 84.3% of the global market. That should be enough to approximate the outcomes of the global market. One could also add a slice of REITs to their portfolio and bring the total to 89.4%, but it doesn't seem strictly necessary. The fees on holding HY bonds and emerging market bonds seems too high to justify adding them, and their slices are so small that it wouldn't matter much anyway. In theory one could hold everything on here except private equity with simple Vanguard funds.
The real takeaway is that you'd not be holding a great deal in stocks .. The decision to hold 60% stocks is really a significant active bet on one particular asset class

Someone who believes in efficient markets *should* (I believe) leverage the risk up, rather than changing the weightings .. According to Shape, you can't get more efficient, so any tinkering is going to be to your detriment
Excuse my ignorance and stupidity but I still do not get it. How do you just 'leverage the risk up' of a bond portfolio? Bonds are already a risk-free asset if held to maturity. There are credit constraints preventing a person from borrowing and investing in bonds. The interest paid usually outweighs the bond yield. So I don't get why efficient market theory always says to just "lever up" when you want to increase risk. This isn't possible or practical for everyone. Instead we should assume leverage is not an option.

The government bonds in the global portfolio are essentially the riskfree asset. Why should the global portfolio offer the optimal combination of risk and reward to every investors? Maybe some people have a higher risk tolerance than average -- why should they hold the average portfolio? It makes sense that people with above average risk aversion should overweight government bonds and people with below average risk aversion should overweight HY bonds and equities.

That's why I think it makes more sense to divide the market into broad asset classes: risky and riskless. Then choose an appropriate combination of the risky and riskless assets to fine-tune one's risk/reward.

So my takeaway from the global cap weight chart is that one should add small slices of REITs, HY bonds, and EM bonds provided the expenses aren't too high. Though they would be such tiny slices that it probably adds no practical benefit for the additional complexity.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by lack_ey »

rca1824 wrote:
Maynard F. Speer wrote:
rca1824 wrote:If that data is true, if you only hold equities + government bonds + corporate bonds, you're holding 84.3% of the global market. That should be enough to approximate the outcomes of the global market. One could also add a slice of REITs to their portfolio and bring the total to 89.4%, but it doesn't seem strictly necessary. The fees on holding HY bonds and emerging market bonds seems too high to justify adding them, and their slices are so small that it wouldn't matter much anyway. In theory one could hold everything on here except private equity with simple Vanguard funds.
The real takeaway is that you'd not be holding a great deal in stocks .. The decision to hold 60% stocks is really a significant active bet on one particular asset class

Someone who believes in efficient markets *should* (I believe) leverage the risk up, rather than changing the weightings .. According to Shape, you can't get more efficient, so any tinkering is going to be to your detriment
Excuse my ignorance and stupidity but I still do not get it. How do you just 'leverage the risk up' of a bond portfolio? Bonds are already a risk-free asset if held to maturity. There are credit constraints preventing a person from borrowing and investing in bonds. The interest paid usually outweighs the bond yield. So I don't get why efficient market theory always says to just "lever up" when you want to increase risk. This isn't possible or practical for everyone. Instead we should assume leverage is not an option.

The government bonds in the global portfolio are essentially the riskfree asset. Why should the global portfolio offer the optimal combination of risk and reward to every investors? Maybe some people have a higher risk tolerance than average -- why should they hold the average portfolio? It makes sense that people with above average risk aversion should overweight government bonds and people with below average risk aversion should overweight HY bonds and equities.

That's why I think it makes more sense to divide the market into broad asset classes: risky and riskless. Then choose an appropriate combination of the risky and riskless assets to fine-tune one's risk/reward.

So my takeaway from the global cap weight chart is that one should add small slices of REITs, HY bonds, and EM bonds provided the expenses aren't too high. Though they would be such tiny slices that it probably adds no practical benefit for the additional complexity.
Closed-end funds are available to retail investors and employ some leverage. Some of the "total return" style bond funds heavy on derivatives may actually be a little leveraged too. For higher multiples, there are 2x daily and 3x daily bond ETFs with the corresponding amount of leverage.

Explicit account margin at InteractiveBrokers is 1.5% + the Fed funds rate (so 1.64% as they calculate) on amounts up to $100K, 0.50% less up to $1M and less when higher than that.

A Treasury bond futures contract commands $100K par value of the underlying bond (well, the amount is larger for the shorter durations like the 2-year I think) and usually has an imputed borrowing cost somewhere a bit above (say 25 bp or so) 3-month LIBOR, compared to actually holding that much of the underlying security.

There are many ways for ordinary retail investors to access leverage, for better or worse, even if segregating mortgages and other loans from the picture.

That said, the idea of leveraging up and down the line in the MPT sense is something of a fantasy or at best a theoretical ideal. There are costs involved that make the trek less steep than that would imply, among other things.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

cottonseed1 wrote:Maybe I am missing something obvious...

Assuming we are in backwards land where all active funds have 25 BP of total frictional cost (fees, taxes etc) and index funds have total frictional cost of 1% on average you would be better off in the active funds. Just as active managers as a whole cannot beat the market because they are the market, they cannot underperform it either. As a group it seems like a logical contradiction to assume that they can outperform or underperform when they make up the market.
Active mutual funds only make up about 30% of most developed markets .. The rest is private investors, insurance companies, government share ownership, etc.

So in less efficient markets, what you're really paying for is resources .. In the Chinese domestic market, for example, you had a situation where indexes returned effectively nothing, while active funds returned >10% (as Malkiel's made an example of) .. Active funds in developed markets can also invest in unlisted companies, or involve themselves and their resources in restructuring and developing existing companies ... So what you're really talking about is the average active dollar (which is quite a nebulous concept)

But irrespective of that - it's whether through factor and risk diversification, breaking away from cap-weighting to perhaps more even-weightings (of size, region, etc), there may be a benefit in diversification that outweighs some additional expense ratios .. The Yale model would perhaps be a working example of that concept
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

rca1824 wrote:Excuse my ignorance and stupidity but I still do not get it. How do you just 'leverage the risk up' of a bond portfolio? Bonds are already a risk-free asset if held to maturity. There are credit constraints preventing a person from borrowing and investing in bonds. The interest paid usually outweighs the bond yield. So I don't get why efficient market theory always says to just "lever up" when you want to increase risk. This isn't possible or practical for everyone. Instead we should assume leverage is not an option.

The government bonds in the global portfolio are essentially the riskfree asset. Why should the global portfolio offer the optimal combination of risk and reward to every investors? Maybe some people have a higher risk tolerance than average -- why should they hold the average portfolio? It makes sense that people with above average risk aversion should overweight government bonds and people with below average risk aversion should overweight HY bonds and equities.

That's why I think it makes more sense to divide the market into broad asset classes: risky and riskless. Then choose an appropriate combination of the risky and riskless assets to fine-tune one's risk/reward.

So my takeaway from the global cap weight chart is that one should add small slices of REITs, HY bonds, and EM bonds provided the expenses aren't too high. Though they would be such tiny slices that it probably adds no practical benefit for the additional complexity.
There's always some risk holding bonds - always a risk they can't be repaid .. Admittedly the US treasury is about as sure a bet as you're likely to get, but countries like Russia have defaulted on domestic debt

Leveraging would just involve borrowing money to buy more of them .. You could use >24 month interest-free credit cards - or family friends - ladder a load of debts up, and have them all paying off on time ... There would be more risk - but it may still be negligible (many economics students seem to leave college and decide to invest like this)

The idea is that between a higher risk asset (stocks) and a lower risk asset (bonds) there's an efficient frontier that provides the best rate of return for a certain level of risk .. There's also an efficient frontier between private equity and hedge funds .. I still think the leveraged global market portfolio takes some beating
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by rca1824 »

Maynard F. Speer wrote:
Leveraging would just involve borrowing money to buy more of them .. You could use >24 month interest-free credit cards - or family friends - ladder a load of debts up, and have them all paying off on time ... There would be more risk - but it may still be negligible (many economics students seem to leave college and decide to invest like this)
That sounds great in theory but doesn't work in practice. Most people aren't going to do that, and I don't think it should be a principle of Bogleheads to do that either. There's also risk, when your 24-mo card has to be paid off, if your portfolio had underperformed, you will be forced to sell it at a loss. What would you do? Only sell the bond allocation? It still feels like chasing after peanuts. Max out a $10k credit card and earn a 2% bond yield and you're only making $200/year for a lot of paperwork and effort. Not recommended.
Monthly or yearly movements of stocks are often erratic and not indicative of changes in intrinsic value. Over time, however, stock prices and intrinsic value almost invariably converge. ~ WB
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

rca1824 wrote:That sounds great in theory but doesn't work in practice. Most people aren't going to do that, and I don't think it should be a principle of Bogleheads to do that either. There's also risk, when your 24-mo card has to be paid off, if your portfolio had underperformed, you will be forced to sell it at a loss. What would you do? Only sell the bond allocation? It still feels like chasing after peanuts. Max out a $10k credit card and earn a 2% bond yield and you're only making $200/year for a lot of paperwork and effort. Not recommended.
Like I said it's very common for economics students to leave college and decide to invest like this (usually with stocks) .. We're far too conservative for it in the UK, so I haven't investigated the best ways to do this .. (I'd probably be tempted to approach wealthy relatives)

I think you'd want to do it with a bond-ladder - rather than bond funds - so you can plan for a stable level of returns .. and I think, if you're going along with the global market concept, you would want to include stocks and alternative assets to optimise the rate of return
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by cottonseed1 »

Maynard F. Speer wrote:
Like I said it's very common for economics students to leave college and decide to invest like this (usually with stocks) .. We're far too conservative for it in the UK, so I haven't investigated the best ways to do this .. (I'd probably be tempted to approach wealthy relatives)
For any investor who is interested in using leverage in their portfolio please read this thread.

http://www.bogleheads.org/forum/viewtop ... sc&start=0

Here are the cliffs:
Summary: Econ grad student applies Mortgage Your Retirement theory at the top of the last bull market, starting around 2x leverage, loses $210K of borrowed money, and is forced is to sell what's left of his portfolio at S&P 821 in November 2008. The complete wipeout results in a reflective period where he recollects the circumstances that led him to adopt this strategy, some of which will be included in a book. He spends five weeks in Asia and begins writing about how risk and progress can be framed. Returning to the US, he slashes his expenses, finds several ways to increase income, earns 914% on the IRBLTG Fund, and pays off all his high interest credit card debt. Net worth tracker continues to be updated.

Current equity exposure target: N/A
Net worth: -$2K
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

cottonseed1 wrote:For any investor who is interested in using leverage in their portfolio please read this thread.

http://www.bogleheads.org/forum/viewtop ... sc&start=0
Absolutely - a must-read

Here's how the Global Market Portfolio (GMP) would have held up

Image

And this may be an argument for barbelling - a Larry-style portfolio: 15% USSV, 15% ISV, 70% 5YT

Image
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

cottonseed1 wrote:Maybe I am missing something obvious...

Assuming we are in backwards land where all active funds have 25 BP of total frictional cost (fees, taxes etc) and index funds have total frictional cost of 1% on average you would be better off in the active funds. Just as active managers as a whole cannot beat the market because they are the market, they cannot underperform it either. As a group it seems like a logical contradiction to assume that they can outperform or underperform when they make up the market.
The problem with this weird reality, is that active managers will have a entire distribution of those underperforming by 3% to those overperforming by 3% because of "good" or "poor" choices in their stock picking or market timing. It would be impossible to figure out which active manager would be the overperforming star or which one would be the long-term lemon. That's the whole point of index funds, because it returns average results, and you can be almost 100% sure that you will get average results, but the returns are independent on the guy managing it.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

AndroAsc wrote:The problem with this weird reality, is that active managers will have a entire distribution of those underperforming by 3% to those overperforming by 3% because of "good" or "poor" choices in their stock picking or market timing. It would be impossible to figure out which active manager would be the overperforming star or which one would be the long-term lemon. That's the whole point of index funds, because it returns average results, and you can be almost 100% sure that you will get average results, but the returns are independent on the guy managing it.
Not meaning to take over this thread, but just on this ..

The actual quote is: "the return on the average actively managed dollar will equal the return on the average passively managed dollar" ... People try to turn this into a more universal principle - e.g. every manager who outperforms equals another who underperforms; for one to outperform by 5% another has to underperform by 5%, etc.. This isn't guaranteed at all

For example, China A-Shares are an example of a less efficient market .. Here the passive returns can differ widely from the professionally managed active returns (implying there's a premium on quality research and information) - whereas in more efficient markets, pricing is so scrutinised that it's more difficult to add value .. Active funds have performed very well in the UK so far this century

Image
https://www.youtube.com/watch?v=uVcV0H4qtgw (36:00 - Malkiel "Investment Opportunities in China")
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by AndroAsc »

Maynard F. Speer wrote:Not meaning to take over this thread, but just on this ..

The actual quote is: "the return on the average actively managed dollar will equal the return on the average passively managed dollar" ... People try to turn this into a more universal principle - e.g. every manager who outperforms equals another who underperforms; for one to outperform by 5% another has to underperform by 5%, etc.. This isn't guaranteed at all

For example, China A-Shares are an example of a less efficient market .. Here the passive returns can differ widely from the professionally managed active returns (implying there's a premium on quality research and information) - whereas in more efficient markets, pricing is so scrutinised that it's more difficult to add value .. Active funds have performed very well in the UK so far this century

Image
https://www.youtube.com/watch?v=uVcV0H4qtgw (36:00 - Malkiel "Investment Opportunities in China")
I am highly skeptical of this. My immediate question would be:
1) Are the active funds investing in the same "general category" as the respective indexes? For example, an active fund heavily tilted into SV may outperform the S&P 500, which is not surprising because of the extra premium from SV, and using this example to show how active management can "add value" is totally misleading.
2) Do these active funds invest in securities not listed in the index? I know that not all shares in China are open to foreign investors, so maybe they have "special access" to some non-tradable securities. Or maybe there is some insider information here? After all, it's China and not a well regulated environment.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

AndroAsc wrote:I am highly skeptical of this. My immediate question would be:
1) Are the active funds investing in the same "general category" as the respective indexes? For example, an active fund heavily tilted into SV may outperform the S&P 500, which is not surprising because of the extra premium from SV, and using this example to show how active management can "add value" is totally misleading.
2) Do these active funds invest in securities not listed in the index? I know that not all shares in China are open to foreign investors, so maybe they have "special access" to some non-tradable securities. Or maybe there is some insider information here? After all, it's China and not a well regulated environment.
You can see it's Malkiel's (author of A Random Walk Down Wall Street) own example .. As such, today he has around 30% of his own portfolio (1 part US stocks, 1 part India and 1 part China) in actively managed funds .. His point was always really about the efficiency of markets - it's perhaps been slightly distorted along the way

1) I think the existence of factors is a philosophical issue .. What we might call SV today is a stone's throw from Ben Graham's investing strategy in the 30s (value, momentum, selling winners, etc) .. I've lost track of how many factors we've identified today - are we closing in on 100?

2) This was all domestic shares to the best of my knowledge, and the discrepancy was especially high *before* the market was open to foreign investors .. So it makes for a good example .. In the UK we have the AIM index - sits somewhere between private equity and smaller companies .. And again, the index returns virtually nothing, while the few active funds investing in the space are some of the highest returning in the market (beating even private equity) .. And what it perhaps suggests is active fund managers (with the resources to meet with 1,000 companies a year) have an information advantage over private investors in the space - who are willing to take on higher risks with start-ups in hopes of finding the next Google, and being major shareholders
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by JoMoney »

AndroAsc wrote:...with SV tilt using DFA funds for example, because it is still more "indexy" than active. I know their fund managers follow a select prescription of rules, and I know the performance is not dependent on the fund manager.
I think that's a matter of opinion, and depends on what you want to call an 'index'. Creating an 'index' that tries to follow the average of a particular active trading style seems pretty active to me. 'Rules based trading' sounds more like a quantitative hedge fund than a broad market index bought and held forever with an attempt to minimize trading.
Back to to 'when does chasing risk factors end?' , I'll suggest maybe it ends when people give up on the idea of the 'Efficient Market Hypothesis' and start looking closer at real securities analysis and valuation of businesses. It's not going to make beating the market any easier, and it would probably lead to people chasing 'hot managers' instead of chasing 'risk factors', but c'est la vie ... people are drawn to chasing performance.
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by afan »

The global passive portfolio is not readily investible by many people. It would certainly include real estate (which the authors exclude because much of it is owner occupied- so what? It is still an investment). This portfolio also ignores nearly all privately held businesses. The private equity slice is only that held in private equity funds. It is easy to understand why they made the latter simplification for convenience, but that does not mean it reflects the real value of risky assets.

The assumption that owner occupied real estate does not count does not make sense.

Depending on where a stock, bond, loan, piece of real estate or other asset may be located and the applicable laws and barriers to entry, many are investable for some investors but not for others. There are assets that have value in North Korea- try going on the NK stock market and bidding for shares.

There are enough factors currently recognized, plus many more waiting in the wings, to provide mutual fund companies and money managers with marketing text for years to come.
We don't know how to beat the market on a risk-adjusted basis, and we don't know anyone that does know either | --Swedroe | We assume that markets are efficient, that prices are right | --Fama
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Beating the market with "factors?"

Post by Taylor Larimore »

There are enough factors currently recognized, plus many more waiting in the wings, to provide mutual fund companies and money managers with marketing text for years to come.
Afan:

A "gem" if there ever was one!

Thank you and best wishes.
Taylor
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

Ha, I always think that's such a negative view ..

If these inefficiencies are still exploitable (even if only for 2 months before everyone piles in) then these funds are doing exactly what an intelligent, self-ordering system should be doing, which is increasing its own efficiency

Eventually we might have a stock market completely immune from bubbles, as easy to invest in as a bank account, and that most importantly allocates capital exactly where it needs to be, supporting innovation and improving the whole global economy ... (as long as we've got a slither of inefficiency to keep active traders competitive)
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
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Yesterdaysnews
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Yesterdaysnews »

All fund shops are not created equal. I believe like anything else in life, there are some active fund shops which are superior and may add value. While most active funds, esp those mainly investing in US large caps, are not worth investing over the passive index, I don't believe this applies to all.

I feel AQR, Artisan, Matthews (for emerging), Harding Loevner (for international) are such superior fund shops.
kolea
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Re: The line between Active vs Passive in blurring: When does chasing risk factors end?

Post by kolea »

JoMoney wrote: Back to to 'when does chasing risk factors end?' , I'll suggest maybe it ends when people give up on the idea of the 'Efficient Market Hypothesis' and start looking closer at real securities analysis and valuation of businesses. It's not going to make beating the market any easier, and it would probably lead to people chasing 'hot managers' instead of chasing 'risk factors', but c'est la vie ... people are drawn to chasing performance.
I don't think it will ever end, it will just get renamed. After all, what we now call factors is pretty much what used to be called fundamental analysis. And even if factors peters out, something else will come up. Your last sentence sums it up - people like to chase performance. I can't see that changing.
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Maynard F. Speer
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Re: The line between Active vs Passive is blurring: When does chasing risk factors end?

Post by Maynard F. Speer »

I think what retail investors really want is a stable return with minimum risk to capital .. And I think funds like QSPIX - and in the UK we've got GARS (which is the largest fund in the UK now) - are probably a glimpse at the future of investing .. especially if we're in for 10-20 years of poor returns from major indices

So whether they're run by computers or fund managers, I'd see things moving towards highly diversified, low-cost multi-asset funds (investing directly in factors, relative value strategies, money lending, farmland, etc.) probably dominated by a handful of major companies, and the choice investors have being which to choose

And what they'll probably provide is the long-term market average from a broadly diversified portfolio, minus fees, but with far fewer surprises (and I think direct stock and bond investing may become very niche, and far more difficult to do well)
"Economics is a method rather than a doctrine, an apparatus of the mind, a technique of thinking, which helps its possessor to draw correct conclusions." - John Maynard Keynes
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