"Factor investing"

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JoMoney
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Re: "Factor investing"

Post by JoMoney »

lack_ey wrote: ...
investorguy1 wrote:3. I haven't done a scientific study but looking at many of these smart beta funds track records they aren't looking too good. I would be very surprised if any where near half have beaten low cost index funds in similar categories.
What do you count under the smart beta category? Do cap weighted factor tilts count? For the non-cap-weighted stuff, which some count as smart beta, some things like the RAFI-based funds did fairly well over the last 10 years, even over a relatively poor period for value. A lot of the category is pretty new yet. I don't know full statistics about this stuff, though.
...
Looking at the the big ideas 10 years ago that Bogle called out in his WSJ OP-ED "Turn on a Paradigm?"
Of the 3 "Smart Beta" styles he pointed out, only the fund indexed to the RAFI (PRF) edged out the broad market (VTI) in terms of total returns
Morningstar Chart
... and it only barely did so in total returns, in terms of measuring it on a "risk adjusted" basis it had higher standard deviation, a lower Sharpe ratio... hardly anything that would suggest anything more than noise, let alone the idea of their being some "risk premium" associated with it.
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Re: "Factor investing"

Post by lack_ey »

JoMoney wrote:
lack_ey wrote: ...
investorguy1 wrote:3. I haven't done a scientific study but looking at many of these smart beta funds track records they aren't looking too good. I would be very surprised if any where near half have beaten low cost index funds in similar categories.
What do you count under the smart beta category? Do cap weighted factor tilts count? For the non-cap-weighted stuff, which some count as smart beta, some things like the RAFI-based funds did fairly well over the last 10 years, even over a relatively poor period for value. A lot of the category is pretty new yet. I don't know full statistics about this stuff, though.
...
Looking at the the big ideas 10 years ago that Bogle called out in his WSJ OP-ED "Turn on a Paradigm?"
Of the 3 "Smart Beta" styles he pointed out, only the fund indexed to the RAFI (PRF) edged out the broad market (VTI) in terms of total returns
Morningstar Chart
... and it only barely did so in total returns, in terms of measuring it on a "risk adjusted" basis it had higher standard deviation, a lower Sharpe ratio... hardly anything that would suggest anything more than noise, let alone the idea of their being some "risk premium" associated with it.
I think when somebody says "beaten" in the context of index funds, that's looking at absolute, not risk-adjusted performance. It could be either though, so it's good to point out.

For PRF specifically, it had slightly worse Sharpe compared to the Russell 1000 but better 3-factor alpha. Fundamental indexing is a kind of variant on value investing and certainly it beat being in an actual value fund over the period or having an equivalent level of value exposure.

Broadly speaking, if you stipulate that smart beta is stuff that's not market cap weighted (so market-cap weighted index funds covering a part of the market don't count), most of the times you're going to end up with a value tilt unless you intentionally are trying not to do that or are running a momentum fund or something like that. Frequently a small tilt too. Value hasn't been great the last 10 years.


Anyway, it's interesting to note that in "Turn on a Paradigm" (2006) he points out that the value spread is small. In the last 10 years, the value spread went from small then to about historically typical now, which is in part responsible for the relatively poor performance of value over the period.
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Re: "Factor investing"

Post by Robert T »

.
Somewhat in contrast to Ozark’s post in 2003 linked in the OP, I am happy I paid attention to the work of academics (notably Fama-French).

From Warren Buffet - "To invest successfully over a lifetime does not require a stratospheric IQ, unusual business insights, or inside information. What's needed is a sound intellectual framework for making decisions…”. For me, the Fama-French (risk) factor model has provided a sound framework for making decisions. Other investors may prefer other frameworks. Seems important to have one.

From John Bogle – “...realize the highest possible portion of the return earned in the financial asset class in which you invest – recognizing and accepting that that portion will be less than 100%" i.e. keep total cost low.

These are neatly summarized by Bernstein "Over the long haul, what matters is factor exposure and expense" (from a 2002 post http://socialize.morningstar.com/NewSoc ... ID=1347999)

My resulting low cost global portfolio tilted to value and small cap stocks with 25 percent bonds has not done too badly so far since setting it up at the start of 2003 (re: Ozark's post date). Annualized returns to date have been 2% higher than a Vanguard Lifestrategy portfolio combination with the same stock:bond ratio.

Obviously no guarantees, and “many roads to Dublin.”

The ‘optimal’ portfolio allocation is one you can stick with over the long-term. As Larry indicated in a earlier post if you don’t have a strong belief in your allocation you will likely not stick with it and bail just at the wrong time.

From Swensen “Without a rock-solid belief in the fundamental principles that undergird an intelligently crafted portfolio, weak-kneed investors face the likelihood of disastrous whipsaw. … Investment success requires the conviction that comes from a fundamental understanding of the rationale for building the portfolio to certain specification.”

Robert
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Re: "Factor investing"

Post by larryswedroe »

investorguy
As I explain in my new book, and have explained here many times, TSM does own about 10% small stocks and about 30% value stocks. Those holdings provide + exposure to the size and value factors. But what you are missing is that the large and growth stocks in TSM provide an exactly offsetting NEGATIVE exposure to the same factors. Hence TSM has no exposure to ANY factor by definition. The positive MOM stocks it owns are exactly offset by the negative MOM stocks, and so on.
To get exposure to a factor you have to own MORE of that factor than does TSM. Try running Vanguard's total market fund in Portfolio Visualizer regression tool and you'll see the results I state.
Hope that clarifies
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"Top Ten Factors To Think About"

Post by Taylor Larimore »

Bogleheads:

Top Ten Factors To Think About

Best wishes.
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Re: "Factor investing"

Post by Kevin M »

    Robert T wrote:The ‘optimal’ portfolio allocation is one you can stick with over the long-term. As Larry indicated in a earlier post if you don’t have a strong belief in your allocation you will likely not stick with it and bail just at the wrong time.

    From Swensen “Without a rock-solid belief in the fundamental principles that undergird an intelligently crafted portfolio, weak-kneed investors face the likelihood of disastrous whipsaw. … Investment success requires the conviction that comes from a fundamental understanding of the rationale for building the portfolio to certain specification.”
    This is just brilliant. Robert, you have exemplified this principle ("conviction that comes from a fundamental understanding of the rationale for building the portfolio to certain specification") in so many of your posts, and I'm always impressed by the analytical fortitude you demonstrate in sticking to a relatively precise tilt to small and value (per your avatar :wink: ).

    I also tilt to small and value, but probably not as much, and certainly not as precisely as you (Robert T). I have enough conviction in the rationale for building my portfolio to a rough (although not precise) specification that I continue to stick with it, despite the mental whipsaw that one can experience in reading so many well-reasoned posts and articles on each side of the debate between the market-cap-weighters and the tilters.

    I really like Bill Bernstein's way of putting it in one of his more recent booklets. Something along the lines of: Just using a 3-fund portfolio is good enough, and will put you way ahead of most other investors, but I still think there's probably a benefit to tilting to small and value. So a single Target Retirement or LifeStrategy fund probably is a great choice for most people, and you probably shouldn't tilt away from a cap-weighted portfolio unless you have a strong conviction that it's the right thing to do for you.

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    Re: "Factor investing"

    Post by larryswedroe »

    Kevin
    I'm giving a talk at our national conference next month based on my new book Your Complete Guide to Factor Based Investing. Here's how I end the talk, with words of caution.

    First, as we have discussed, all factors, including the ones i have recommended, have experienced long periods of underperformance. Thus, before investing you should be sure that you have a strong belief in the rationale behind the factor and the reasons why you believe it will persist in the long run. The reason is that without this strong belief it is unlikely that you will be able to maintain discipline during the inevitable long periods of underperformance. And discipline is A key to being a successful investor. And finally, because there is no way to know which factors will deliver premiums in the future, i recommend that you build a portfolio that is broadly diversified across factors. Remember, it’s been said that diversification is the only free lunch in investing. Thus, I recommend you eat as much of it as you can!
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    Re: "Factor investing"

    Post by bertilak »

    larryswedroe wrote:Kevin
    I'm giving a talk at our national conference next month based on my new book Your Complete Guide to Factor Based Investing. Here's how I end the talk, with words of caution.

    First, as we have discussed, all factors, including the ones i have recommended, have experienced long periods of underperformance. Thus, before investing you should be sure that you have a strong belief in the rationale behind the factor and the reasons why you believe it will persist in the long run. The reason is that without this strong belief it is unlikely that you will be able to maintain discipline during the inevitable long periods of underperformance. And discipline is A key to being a successful investor. And finally, because there is no way to know which factors will deliver premiums in the future, i recommend that you build a portfolio that is broadly diversified across factors. Remember, it’s been said that diversification is the only free lunch in investing. Thus, I recommend you eat as much of it as you can!
    (my emphasis)

    Larry,

    You say one needs a strong belief to ensure discipline. I think there is more to it than maintaining discipline -- understanding separates belief from blind faith. One cannot (or should not!) have a "strong belief" in something one does not understand.

    I have expressed misgivings about factor investing in this and other threads here on Bogleheads.org, often questioning the reasoning behind the concept. I should clarify that my comments were an attempt to understand.

    One cannot jump from one belief to another without first having some idea that the concept is likely to reward investigation and eventual understanding. There are too many possibilities to investigate every investment theory one hears about. Personally I don't have the energy to do so and frankly I don't trust my skills in the more complex areas.

    But, I have heard enough about factor investing to believe I might benefit from it. So, I will be reading your book!

    QUESTION: Are there special considerations for retirees? For example, "inevitable long periods of underperformance" may be more of a problem (aka risk) for a retiree. Or, using Dr. Bernstein's terminology, is it "shallow risk" for the young and "deep risk" for the older retiree?
    Last edited by bertilak on Sun Sep 11, 2016 8:46 am, edited 1 time in total.
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    Diversification: The Good. The Bad,

    Post by Taylor Larimore »

    larryswedroe wrote: Remember, it’s been said that diversification is the only free lunch in investing.
    Larry:

    Nice ending.

    This does not apply to you, but we must also remember:
    Mr. Bogle wrote:"Diversification is the last refuge of the scoundrel."
    Best wishes
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    Last edited by Taylor Larimore on Sun Sep 11, 2016 8:49 am, edited 1 time in total.
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    Re: Diversification: The Good. The Bad,

    Post by bertilak »

    Taylor Larimore wrote:This does not apply to you, but we must also remember:
    Mr. Bogle wrote:"Diversification is the last refuge of the scoundrel."
    Taylor,

    That quote surprises me. Can you tell me where it came from? Was it in some special context?
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    Re: "Factor investing"

    Post by vencat »

    This may have been the full quote:

    And let me say this about a better diversifier: "Better diversification" is the last refuge of the scoundrel. -- Anything that's done well recently is considered a great diversifier.
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    Jack Bogle: "Liquidity Is the Last Refuge of the Scoundrel"

    Post by Taylor Larimore »

    bertilak wrote:
    Taylor Larimore wrote:This does not apply to you, but we must also remember:
    Mr. Bogle wrote:"Diversification is the last refuge of the scoundrel."
    Taylor,

    That quote surprises me. Can you tell me where it came from? Was it in some special context?
    Bertilak:

    You will find it in this headline:

    Diversification Is The Last Refuge of the Scoundrel

    Best wishes.
    Taylor
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    Re: "Factor investing"

    Post by GreatOdinsRaven »

    The full context of Mr. Bogle's quote is as follows: italics are mine:


    "That's the way I feel, as you probably know, about international stocks. If they're efficiently priced, I just don't see why they would give you a higher return in the future than they're giving you today.

    And let me say this about a better diversifier: "Better diversification" is the last refuge of the scoundrel. What were we talking about five years ago as a good diversifier? Well, I can't remember, but it wasn't gold. And when gold does well, as it certainly has, then someone says it's a great diversifier. And when international bonds get a little ahead of U.S. bonds—not before, but after—then someone says it's a great diversifier. Anything that's done well recently is considered a great diversifier."

    Full interview link: http://www.etf.com/publications/journal ... nopaging=1

    I can't speak for Larry, but he doesn't seem to be saying let's diversify by buying what's been hot. (In fact value hasn't done well for quite some time). Rather he's saying we can't know what's going to perform well so pick a diversified AA (using factors such as beta, (or value or momentum if you so choose), stick with it and rebalance as necessary. Perhaps I'm missing the point. It's always so hard to read between the lines and infer tone on an Internet forum.
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    Re: "Factor investing"

    Post by larryswedroe »

    bertilak
    Of course a strong belief system needs to be based on understanding the rationale for the belief. In the new book I present the academic evidence for the intuitions behind each factor so that each person can then draw their own conclusions.

    Taylor,
    Here's my own statement about diversification.Diversification is only for those who don't have clear crystal balls.
    But also here's Peter Bernstein's I’m a big believer in diversification, because I am totally convinced that forecasts will be wrong. Diversification is the guiding principle. That’s the only way you can live through the hard times. It’s going to cost you in the short run, because not everything will be going through the roof. —Peter Bernstein, Jonathan Burton, Investment Titans. (McGraw-Hill, 2001), p.. 207.

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    Re: "Factor investing"

    Post by nisiprius »

    That's the great mystery, isn't it? In our hearts, which do we believe:

    1) Diversification is the only free lunch, or
    2) There ain't no such thing as a free lunch?

    I think that it is psychologically safer for me to believe that there ain't no such thing as a free lunch, even if it means passing up the occasional free snack, then to start believing in free lunches.*

    The problem with "diversification is the only free lunch" is that having said that, you need to ask "how big is it? That free lunch, how much is it in dollars?" and, the biggy, "what counts as diversification?"

    There's no getting around it: there's one faction that believes that cap-weighting represents maximum diversification, and another that believes that factor-based and "smart beta" portfolios are more diversified than total market portfolios. To me, it is obvious that a small value tilt represents a both a loss of diversification and a "bet." The factor mavens retort that it is I who am betting... on large-caps in particular. I won't try to present the argument for either point of view.

    The argument for diversification being a free lunch is subtle. It amounts to a claim that market forces can act only on individual securities, and cannot possibly act on groups of them. The basic intellectual point is that the risk-reward characteristics of a portfolio are different from the sum of its parts. In an extreme case, if we imagine a pair of stocks X and Y that, over some period of time in the past, have had the same return, the same volatility, and low correlation, than, over that period of time, a portfolio X+Y of the two will have had the same return but lower volatility than either X or Y.

    The implication, then, is that the act of adding Y to a portfolio containing X actually adds value to both of them. As an investment, measured by risk-adjusted reward, Y becomes a better investment through the act of selecting it into a portfolio.

    But the market sets only one price for Y. (??? Is this really true? ... wonders...) Either the market price for Y is too high when it is outside the portfolio, or it is too low when it is inside the portfolio.

    The theory of the "free lunch" assumes that the market takes no notice of the way people are combining securities into portfolios, and that the existence of factor-based portfolios can't possibly affect the price of the securities that are most valuable for building those portfolios.

    I'm not enough of an economist to know what the theory predicts ought to happen, but I don't think the market is stupid enough not to notice factor-based investing at all. It is not a world in which factor-based portfolio construction is effectively secret inside information that lets us get all the benefit without the market noticing what we are doing. There may have been a period of time when, effectively, it really was.

    I believe that any "free lunch" from factor-aware portfolios is likely to be temporary, and suffer from a decline effect--both from the scientific research "decline effect" in which the effect isn't as real or a strong as initial publications suggest, because the publication process selects for dramatic and strong results and thus publicizes things that are just luck--and from the market darn well bidding up the stocks that are richest in the most fashionable factors. I think that actually happens, and it's why the factor mavens need to keep discovering fresh new factors: it's because the old ones keep losing steam.

    Jared Kizer, who advocates factor-based investing, has written:
    Regarding post-publication, the thinking here is that after a factor premium is discovered it may become commoditized to some degree. While this need not completely eliminate the premium, it could certainly reduce the size of the premium in future periods.
    I think it's important to add, because it's so frequently raised as a straw man, that popularity cannot change the effectiveness of cap-weighted total-market indexing. It is at least possible for investors to bid up the prices of small value stocks as a class, or low-volatility stocks as a class, or dividend stocks as a class, making them overvalued. There is no way to bid up the prices of the stocks in the Vanguard Total Stock Market Index Fund and make them overvalued relative to the rest of the market, because there isn't any "rest of the market" (to speak of).

    *Historically, there really was such a thing as a free lunch--the phrase actually refers to the free lunches customarily provided by saloons in the United States in the 1800s and early 1900s. They were apparently real lunches worthy of the name, not just snacks, and they were apparently often very good; foreign travelers raved about them. They drove temperance reformers bananas; Wikipedia quotes one as lamenting that during a crisis in 1904, the saloons with free lunches "fed more hungry people in Chicago than all the other agencies, religious, charitable, and municipal, put together." So to use a little overwrought rhetoric, may it's psychologically safer for me to act as if "there ain't no such thing as a free lunch" than to let myself be lured into saloons and fall prey to the Demon Alcohol!
    Last edited by nisiprius on Sun Sep 11, 2016 10:13 am, edited 11 times in total.
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    Re: "Factor investing"

    Post by Johnnie »

    bertilak wrote: QUESTION: Are there special considerations for retirees? For example, "inevitable long periods of underperformance" may be more of a problem (aka risk) for a retiree. Or, using Dr. Bernstein's terminology, is it "shallow risk" for the young and "deep risk" for the older retiree?
    Good question. I have an issue related to this.

    I'm a recent convert to Bogleheadism, slice-and-dice division, and am in the midst of what has become a 15 month conversion from a mess of a portfolio and no plan to nearly the same portfolio Paul Merriman described on the first page of this thread.

    One minor inconvenience is that my "legacy" holdings included a small cap value fund that grew to 25 percent of equities.

    Now four-to-six years from retirement, I'm loath to lighten that SCV comittment because, hey, I've already shown the discipline to hold it through one of those "long periods of underperformance!" Who knows what the future will bring, but now I fear lightening up in case that reverses going forward.
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    Re: "Factor investing"

    Post by larryswedroe »

    Johnie
    Here's something from my talk on the new book that I think will help you

    An argument that I often hear from older investors goes like this: I don’t have 20 years to wait to earn a Factor’s premium. The answer is simple. We live in a world where all crystal balls are cloudy. And even worse is that investing isn’t even about risk. It’s about uncertainty. Unlike at the poker table where we can calculate the odds of drawing to that full house, with investing we don’t know the odds of having another event like we had on 911, or another global financial crisis like we experienced in 2008. The best we can do is to estimate the odds of negative outcomes based on history. But we can never know the odds. And the research shows that investors much prefer to make “bets,” or investments, where they know the odds to those where at best they can only estimate the odds. In fact, that’s one of the Explanations for the historically high equity premium. Investors require a high premium to accept the risk of uncertainty.

    The book presents the evidence that no matter what the factor is, including market beta, there are some odds of failure regardless of horizon. Though in the case of each of the factors the longer the horizon the lower the odds of underperformance (almost in every case). And the evidence shows that a portfolio of factors has less risk of failure than even the factor with the highest odds of success, regardless of horizon, at least historically.

    And finally, clearly diversification is a free lunch IF done properly as it lowers the risks (dispersion of potential outcomes) without lowering the expected return.

    Larry
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    Re: "Factor investing"

    Post by lack_ey »

    nisiprius wrote:The theory of the "free lunch" assumes that the market takes no notice of the way people are combining securities into portfolios, and that the existence of factor-based portfolios can't possibly affect the price of the securities that are most valuable for building those portfolios.
    This is not necessarily true. We know in the real world that markets aren't perfectly efficient. It is then plausible that it is less efficient at pricing some relationships than other relationships. If you look at which types of trades and relationships get more attention and are easier to resolve, these may be the ones that are more efficiently priced. It's not that the market continues on ignorant of factor relationships and how securities can be combined into portfolios. But there may be too much capacity and not enough money pushed around to completely "fix" the risky, long-term trades corresponding to some factors, especially because a lot of money invested is not interested in the longer term of several years and more—most managers would be out of a job after a few bad years, and of course there's a lot of short-term trading too. There are sometimes rational incentives for managers to own long the short (bad) sides of a factor.

    Market pricing for securities is not based on the opinion of all investors. It's just based on transaction points, which could be pushed by a small minority.

    Now, there's a question of whether any or which of the common factor strategies capitalize on any of these things, assuming they exist. Arbitrary slices of the markets probably wouldn't.
    nisiprius wrote:There is no way to bid up the prices of the stocks in the Vanguard Total Stock Market Index Fund and make them overvalued relative to the rest of the market, because there isn't any "rest of the market" (to speak of).
    You're not looking at the right relationship there. You could just as easily say that there's no way to make small caps overvalued relative to small caps.

    The point there to make is that there's an easy way (and it's been done before) for the prices of stocks in the total market to be bid up relative to other assets. And this can reduce the subsequent performance of the market factor. This should be relevant if you're allowed to invest in anything other than stocks (cash, if nothing else, or bonds).
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    Re: "Factor investing"

    Post by nedsaid »

    paul merriman wrote:I don't consider "factor" investing an attempt to beat the market.

    Nedsaid: I went to a couple seminars put on by your company back in 2007-2008 which were presented by Tom Cock. I was very impressed by the presentation and in fact had a free telephone session with one of your advisors. I thought the whole rationale of Small/Value/REIT tilting was to beat a standard portfolio using the very broad Indexes. That is why I made changes to my portfolio based upon your firm's advice. The idea was to add return and reduce volatility.

    I consider the addition of other than large cap blend (S&P or Total Stock Market) to simply be different markets.

    Nedsaid: Paul, this is a great point. The top 100 stocks by market capitalization make up just over 50% of the US Total Stock Market Index. Since the S&P 500 is about 75% of the US Total Stock Market, really what you are buying is large growth when you buy US Total Stock Market Index. Not only in effect a large cap index, but a mega-cap index at that.

    We know that Small and Large and Value and Growth lead the market at different times. This is a diversifying across factors as Larry Swedroe described. I have made the argument that even if you don't add return, over time you should lessen volatility.

    The problem is that nothing works all the time. My experience was that the slicing and dicing I did before the 2008-2009 financial crisis probably added volatility rather than decreased it. What worked great in 2000-2002 didn't work in 2008-2009. Having said that, I still believe that my decision to Small/Value tilt my portfolio was the correct choice, my timing wasn't the best.


    I'm not worried about beating any market but I am attempting to earn the best return I can within my risk tolerance. If I were in the accumulation stage of life, I would expect dollar cost averaging into a group of productive asset classes as one way to do better than the average investor but not better than the market. I sponsor Personal Investing 216 at Western Washington University. These students get almost 40 hours of education about how to make a lifetime of good investment decisions. By the way, the class does not discuss spend a minute on how to select a god stock but many hours about how to select a productive asset class. Those students are very likely to have at least 25% of their portfolio dedicated to index funds or ETFs that represent small cap value. Here is one of the many tables they get in the class
    http://paulmerriman.com/four-fund-solution-table/.

    Nedsaid: Value underperformed Growth from about 2010 through 2015 so one invested in a Small/Value tilted portfolio would probably be a bit disappointed. But I do remember your representative saying that a simple Vanguard portfolio would do better than the Merriman portfolio during times when Growth outperformed Value. Since Value outperforms Growth and Small outperforms Large over long time periods, one would expect a Merriman DFA portfolio to win out over longer time periods. But again, the whole reason I did this was to attempt to get a 0.50% to 1.00% per year excess performance over the broad indexes. I am trying to beat the market.

    If the future looks anything like the past stocks will likely make more than bonds, small stocks will likely make more than large, value stocks will make more than growth and a well diversified portfolio can have significant holdings in REITs, emerging markets and other international asset classes. Since I don't trust the future to look like the past, I have approximately equal positions in all these equity asset classes.

    Nedsaid: I agree with this.

    I like the comment "that's good enough for me," referring to accepting whatever the outcome of large cap blend will make. I have no problem with that stance. At 72 I have half my investments in bonds and half in equities and that's "good enough" for me. I take out 5% of my portfolio the first of each year and that's "good enough" for my wife and me to enjoy our retirement. I pay an advisor to oversee my portfolio and take care of all of the details that I don't have an interest in monitoring. I might make more or less without an advisor but having one is "good enough" for us. I know at least 10 things I could do to make more and leave more but what we are doing is "good enough." For those who follow my marketwatch.com articles I will write a future articles on those 10 ways I could make more.

    Nedsaid: I am considering the advisor route myself for whatever point that I don't want to manage my own investments.

    Since I retired almost 5 years ago I have helped a lot of people find a place for their money where it could be "good enough." I suggest many of those people put their long term investments in a combination of Vanguard Wellington and Wellesley. I have never had one of them come back and ask for a better recommendation. For those really interested in how I build a portfolio, I will have a free 2 1/2 hour video on the topic in a couple of weeks.


    Nedsaid: Paul, thanks for all you do. Your firm introduced me to the Fama/French academic research and to Small/Value tilting. You and your firm have given away literally millions of dollars of financial advice for free. I was one of the beneficiaries. Thanks again.
    A fool and his money are good for business.
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    Re: Diversification: The Good. The Bad,

    Post by nedsaid »

    Taylor Larimore wrote:
    larryswedroe wrote: Remember, it’s been said that diversification is the only free lunch in investing.
    Larry:

    Nice ending.

    This does not apply to you, but we must also remember:
    Mr. Bogle wrote:"Diversification is the last refuge of the scoundrel."
    Best wishes
    Taylor
    Taylor, I don't think Mr. Bogle is telling us not to diversify. Otherwise we would all be scoundrels. I think what Bogle was referring to is chasing what has been hot and trendy. Whenever brand X asset class has recently done well, it becomes a "must have" diversifier. Pretty much fill in the blank. In recent years such things as precious metals, commodities, currencies, hedge funds, structured notes have been touted as needed diversifiers in a portfolio. A lot of this is just good old fashioned salesmanship.

    I see nothing wrong with adding asset classes if they have good long term returns and if there is good research and a good rationale for owning them.

    The trouble is that it is not always easy to know the difference between an asset class that is recommended because of strong recent performance or one that is recommended because of strong research and reasoning behind it. For example, many Bogleheads have become disenchanted with TIPS. It used to be standard advice around here to have half of a bond portfolio in TIPS. REITs are another asset class that many here, including myself, have less enthusiasm for now than before.

    Indeed, Vanguard has added a fourth asset class to its model portfolios, International Bonds. There are folks wondering if this is just a fad.
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    Re: "Factor investing"

    Post by vv19 »

    larryswedroe wrote:investorguy
    As I explain in my new book, and have explained here many times, TSM does own about 10% small stocks and about 30% value stocks. Those holdings provide + exposure to the size and value factors. But what you are missing is that the large and growth stocks in TSM provide an exactly offsetting NEGATIVE exposure to the same factors. Hence TSM has no exposure to ANY factor by definition. The positive MOM stocks it owns are exactly offset by the negative MOM stocks, and so on.
    To get exposure to a factor you have to own MORE of that factor than does TSM. Try running Vanguard's total market fund in Portfolio Visualizer regression tool and you'll see the results I state.
    Hope that clarifies
    Larry
    Are you implying that investing in TSM is not an efficient way of investing, then? Also, might be a naive question, but when you talk about factor investing, are you only talking about tilting to SV?
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    Re: "Factor investing"

    Post by larryswedroe »

    Jay
    I would not say that though TSM
    a) includes assets that have been shown to be very poor investments (those lottery tickets) which simply screening them out would improve performance.
    b) and while highly diversified by number of stocks, industries, etc, has no diversification across factors that explain the variation of returns. Thus, IMO a more efficient portfolio can be constructed that uses factors with premiums to diversify the risks away from just market beta, and use the premiums then to lower exposure to beta overall and add safe bonds. You are able to do that because the equities you own have higher expected returns. The diversification benefits are laid out in my book Reducing the Risk of Black Swans. Such portfolios have dramatically reduced volatility and tail risks.
    c) Tilting to small and value, and using that to lower beta exposure has improved risk/return historically. But IMO one can go beyond that adding other factors such as momentum, profitability/quality, carry and TERM. And can add exposure to those factors across asset classes as well, further diversifying the portfolio risks. And then I have added other sources of returns recently including a reinsurance fund which has equity like returns with lower volatility than market and no correlation to stocks. The logic and evidence is provided on the aforementioned factors in my new book which should be out within 2 months.

    Hope that helps
    Larry
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    Re: "Factor investing"

    Post by kolea »

    larryswedroe wrote: And finally, clearly diversification is a free lunch IF done properly as it lowers the risks (dispersion of potential outcomes) without lowering the expected return.

    Larry
    I am not a factor investor because I am 65, pretty risk averse at this point, and to pivot away from TSM would seem to be present a risk to me I am unwilling to take. So I am staying the course. But I am nevertheless quite interested in the theory. Part of the factor argument seems to come down to diversification - is diversifying over factors superior to diversifying over the entire market in a cap-weighted fashion? I really don't know but I am looking forward to Larry's book which hopefully will tell me.

    So, how much will the book cost and is there a discount for members of this forum? :)
    Kolea (pron. ko-lay-uh). Golden plover.
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    Re: "Factor investing"

    Post by larryswedroe »

    Kokea
    I don't know the costs yet, but think something like $13 for paperback and $10 for Eversion perhaps. But I don't know yet. This book is more similar in length to my earlier books, with a tremendous amount of data. It is approximately 270 pages long.

    FWIW, I'm same age and I make heavy use of factors and as I explain in Reducing the Risk of Black Swans there are TWO, not one major benefits of tilting portfolios. The first as you note is to diversify across factors, which the research shows has been more efficient than diversifying across asset classes. That case was well made in the 2012 paper by Antti Illmanen and Jared Kizer in their paper The Death of Diversification Has Been Greatly Exaggerated which won the very prestigious best paper of the year for the Journal of Portfolio Management. The second is the one I made in the Black Swan book and have discussed here many times is that because when you diversify across factors with premiums above the market, you can take less equity risk to achieve the same expected returns. And because of the low correlation of the factors added and then holding more safe bonds you have historically been able to dramatically reduce tail risk. Thus to me the people for whom this strategy is actually the best is the retirees for whom tail risk reduction is the most important. Thus the very people who don't seem to want the risk (they might not understand it) are the ones who would have benefited the most from using it. [OT comment removed by admin LadyGeek]

    Best wishes
    larry
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    Re: "Factor investing"

    Post by nedsaid »

    nisiprius wrote:That's the great mystery, isn't it? In our hearts, which do we believe:

    1) Diversification is the only free lunch, or
    2) There ain't no such thing as a free lunch?

    I think that it is psychologically safer for me to believe that there ain't no such thing as a free lunch, even if it means passing up the occasional free snack, then to start believing in free lunches.*

    Nedsaid: I always thought of diversification as spreading your risk around, not having all your eggs in one basket. Never thought of it as a way of boosting returns until I came across the academic research through Paul Merriman's company. The idea is that by adding non-correlating asset classes which have good long term performance records to the US Stock Market (beta), that you can boost returns and decrease volatility.

    The slicing and dicing worked great in 2000-2002 and didn't work in 2008-2009. Correlation of asset classes tends to increase in times of crisis. Also the behavior of asset classes don't always meet investor expectations. Good investment strategies work but not all the time.


    The problem with "diversification is the only free lunch" is that having said that, you need to ask "how big is it? That free lunch, how much is it in dollars?"

    Nedsaid: My expectation from small/value tilting was to boost my returns 0.50% a year to 1.00% a year. Merriman said that over long periods of time that their managed portfolio of DFA funds would outperform a portfolio of similar Vanguard funds by 1% a year. Seeing that they were charging 1%, Merriman thought they could boost returns by 2% a year.

    and, the biggy, "what counts as diversification?"

    Nedsaid: The essential asset classes are equities and fixed income. Some say stocks, bonds, and cash. Beyond that, you get into the sub-asset classes: Large and Small, Value and Growth, US and International. Then you get sub sub-asset classes, let's take International. Developed and Emerging, Large and Small, Value and Growth. So now you have Emerging Markets Small Value. You get to slicing the pizza into smaller and smaller pieces. It reminds me of the Yogi Berra quote, "Slice the pizza into four slices, I am not hungry enough to eat six." As the pieces get smaller and smaller, you wonder if any one piece will make any difference. This is an excellent question.

    You could then say financial assets and real assets, "real" being physical assets as directly owned real estate, commodities, precious metals, etc. I suppose you could have "real real" assets which are directly owned and "real" assets owned through some sort of derivative instrument.


    There's no getting around it: there's one faction that believes that cap-weighting represents maximum diversification, and another that believes that factor-based and "smart beta" portfolios are more diversified than total market portfolios. To me, it is obvious that a small value tilt represents a both a loss of diversification and a "bet." The factor mavens retort that it is I who am betting... on large-caps in particular. I won't try to present the argument for either point of view.

    Nedsaid: This is where I start disagreeing. We know that different sections of the stock market act differently. We see US vs International, Value vs. Growth, and Small vs. Large trends in the stock market. The 1990's were a U.S. and Large Growth decade. Not that International or US Small or that US Value did badly just that US, Large, and Growth did better.

    The 2000's were the flip side of that. International, Small, and Value did better.

    So really factor investing is sorting stocks by their characteristics. We used to call these investing styles but now we call them factors.

    So if you invest in the Total US Stock Market, by definition you are exposed to beta or market risk. That's it. You can also invest by size and value characteristics which by definition causes you to tilt and overweight stocks with particular characteristics. So you then have beta or market, size, and value. You are invested across three factors and not one. As I alluded to earlier, factor investing worked brilliantly in 2000-2002 and failed in 2008-2009.

    During the lost decade of the 2000's, my portfolio did better than the S&P 500 because I had International, Value, and Mid-Cap/Small-Cap. REITs helped a lot too. It made the "lost decade" look not so bad. Of course, I didn't know what I was doing but I knew about investment styles. It made intuitive sense to diversify across investment styles. Now I am enlightened and call them factors instead.


    The argument for diversification being a free lunch is subtle. It amounts to a claim that market forces can act only on individual securities, and cannot possibly act on groups of them. The basic intellectual point is that the risk-reward characteristics of a portfolio are different from the sum of its parts. In an extreme case, if we imagine a pair of stocks X and Y that, over some period of time in the past, have had the same return, the same volatility, and low correlation, than, over that period of time, a portfolio X+Y of the two will have had the same return but lower volatility than either X or Y.

    Nedsaid: What diversification does is reduce specific stock risk. Also a portfolio that contains more securities will tend to be a bit less volatile than a portfolio of fewer securities. This is pretty widely known though beyond a certain point you get diminishing returns pretty quickly. My suspicion is that you see diminishing returns after about 30 stocks. Beyond that point, as you add more and more securities volatility will decrease but the decrease in volatility gets incrementally smaller and smaller as you add more and more securities.

    The implication, then, is that the act of adding Y to a portfolio containing X actually adds value to both of them. As an investment, measured by risk-adjusted reward, Y becomes a better investment through the act of selecting it into a portfolio.

    Nedsaid: You would think so but there is a real world aspect to this. The problem is that you can't test live with investments, the testing is all done with past data. We all know that securities don't have to perform according to expectations. In other words, past performance is no guarantee of future performance. My best guess is that slicing and dicing would add a certain synergy to the portfolio much of the time but there are times this wouldn't seem to work.

    In your example, X and Y together become a better investment than X by itself because Y has characteristics that will cause it to act differently than X. Hopefully, X and Y together will have a bit higher returns and lower volatility than just X. In 2000-2002, X zigged while Y zagged and that reduced the portfolio volatility. In this situation, you might get a rebalancing bonus from rebalancing between X and Y. During the 2008-2009 financial crisis, both X and Y crashed.


    But the market sets only one price for Y. (??? Is this really true? ... wonders...) Either the market price for Y is too high when it is outside the portfolio, or it is too low when it is inside the portfolio.

    Nedsaid: The flaw in your example is that Y will be owned by somebody. The mere fact that Y changes hands doesn't cause any change in its characteristics other than maybe price. If there is a perfect buy/sell order balance in Y, the transaction will cause no change of price. Only when there is an imbalance in orders, and the price of Y rises or drops enough to where a buyer will step in, will the transaction itself affect the price.

    Now if the academics write a bunch of articles about the superiority of Y as an investment and buyers get interested, that could boost the price of Y. But the mere fact of adding Y to the portfolio changes nothing in the characteristics of Y.

    The whole point is that X and Y will perform better than just X by itself.


    The theory of the "free lunch" assumes that the market takes no notice of the way people are combining securities into portfolios, and that the existence of factor-based portfolios can't possibly affect the price of the securities that are most valuable for building those portfolios.

    Nedsaid: The market takes notice, but human nature is at work here. We gravitate to what has recently done well and we like what other people like. In other words, human nature gravitates towards Large Growth. Wall Street research focuses on the largest companies. The free lunch comes from the behavioral errors that investors make again and again. I believe that the institutions are not immune from such errors though they should be more knowledgeable and less emotional than the individual investor.

    I'm not enough of an economist to know what the theory predicts ought to happen, but I don't think the market is stupid enough not to notice factor-based investing at all. It is not a world in which factor-based portfolio construction is effectively secret inside information that lets us get all the benefit without the market noticing what we are doing. There may have been a period of time when, effectively, it really was.

    Nedsaid: What the academics are saying is nothing new. Market participants have known about or suspected these things for many years. The academics provided more evidence for and more clearly defined the factors. We used to call them styles.

    I believe that any "free lunch" from factor-aware portfolios is likely to be temporary, and suffer from a decline effect--both from the scientific research "decline effect" in which the effect isn't as real or a strong as initial publications suggest, because the publication process selects for dramatic and strong results and thus publicizes things that are just luck--and from the market darn well bidding up the stocks that are richest in the most fashionable factors. I think that actually happens, and it's why the factor mavens need to keep discovering fresh new factors: it's because the old ones keep losing steam.

    Jared Kizer, who advocates factor-based investing, has written:
    Regarding post-publication, the thinking here is that after a factor premium is discovered it may become commoditized to some degree. While this need not completely eliminate the premium, it could certainly reduce the size of the premium in future periods.
    I think it's important to add, because it's so frequently raised as a straw man, that popularity cannot change the effectiveness of cap-weighted total-market indexing. It is at least possible for investors to bid up the prices of small value stocks as a class, or low-volatility stocks as a class, or dividend stocks as a class, making them overvalued. There is no way to bid up the prices of the stocks in the Vanguard Total Stock Market Index Fund and make them overvalued relative to the rest of the market, because there isn't any "rest of the market" (to speak of).

    Nedsaid: If I am correct that these phenomenon are based upon human behavior, you would expect them to go away for a while and at some point come roaring back with a vengeance. The quants cannot repeal human nature which will reassert itself at some point. Ask yourself this question: Why is it that sometimes Growth does better than Value and sometimes Value does better than Growth? Why do we see Small vs Large trends? If markets were as efficient as folks say they are, the performance of Growth and Value, Small and Large ought to be identical all the time. But they aren't. Pretty much, this indicates that investor preferences change. Hemlines go up and they go down. Ties go from narrow to wide and back again to narrow.

    *Historically, there really was such a thing as a free lunch--the phrase actually refers to the free lunches customarily provided by saloons in the United States in the 1800s and early 1900s. They were apparently real lunches worthy of the name, not just snacks, and they were apparently often very good; foreign travelers raved about them. They drove temperance reformers bananas; Wikipedia quotes one as lamenting that during a crisis in 1904, the saloons with free lunches "fed more hungry people in Chicago than all the other agencies, religious, charitable, and municipal, put together." So to use a little overwrought rhetoric, may it's psychologically safer for me to act as if "there ain't no such thing as a free lunch" than to let myself be lured into saloons and fall prey to the Demon Alcohol!
    A fool and his money are good for business.
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    Taylor Larimore
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    Re: "Factor investing" study

    Post by Taylor Larimore »

    Bogleheads:

    Nisiprious has posted this interesting study comparing two factor-based portfolios with The Three-Fund Portfolio.

    An "out of sample" test of two specific factor-based portfolios published pre-2008

    Past performance does not predict future performance.

    Best wishes.
    Taylor
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    Re: "Factor investing"

    Post by Random Walker »

    I disagree with the idea that TSM cannot be bid up the way an individual asset class can be. First of all I do think an entire stock market can be bid up as more people enter the market. Remember 2000 when waitresses and taxi drivers were giving stock tips? Secondly, TSM is dominated by Large Growth. So large growth bubbles, such as technology crazes, will lift the whole index.

    Dave
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    Re: "Factor investing"

    Post by larryswedroe »

    Random
    Of course that is true, and it is the growth stocks which dominate the market that are the most susceptible to bubbles. Value by definition isn't, as it's always the 30% cheapest of stocks. All that can happen is that the spread in expected returns between them narrows.
    Larry
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    Re: "Factor investing"

    Post by investorguy1 »

    lack_ey wrote:It is by construction that the total market doesn't have anything but the market factor. That doesn't mean the total market is deficient in any way. It means that it's not tilted.

    I was serious btw. I think I understand your explanation more than I do larry's.


    What do you count under the smart beta category?
    some of the funds I looked at were MTUM vs VUG (pretty similar returns), GSLC (Goldman multi factor smart beta), I also looked at the iShares smart beta ETFs which as far as performance goes don't seem to be doing much compared to vanguard ETFs.


    Elegance and tracking error regret are kind of behavioral considerations. Similarly, does it really matter what the majority of investors make and whether you beat them? It's relevant broadly but I think we've mostly been talking about raw risk and return considerations. Once you figure out what something does, then you can examine if you can stick with it and if it's worth the time, mental energy, and so on.

    You should always consider costs and taxes, yes. An alternative strategy has to have benefits net of additional costs and taxes to be worth consideration. And that can't be evaluated unless you have some idea of the gross benefits to begin with, which you'd need to put numbers to.
    great points thanks for the perspective.
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    Re: "Factor investing"

    Post by investorguy1 »

    larryswedroe wrote:investorguy
    As I explain in my new book, and have explained here many times, TSM does own about 10% small stocks and about 30% value stocks. Those holdings provide + exposure to the size and value factors. But what you are missing is that the large and growth stocks in TSM provide an exactly offsetting NEGATIVE exposure to the same factors. Hence TSM has no exposure to ANY factor by definition. The positive MOM stocks it owns are exactly offset by the negative MOM stocks, and so on.
    To get exposure to a factor you have to own MORE of that factor than does TSM. Try running Vanguard's total market fund in Portfolio Visualizer regression tool and you'll see the results I state.
    Hope that clarifies
    Larry
    I've read some of your other posts on the subject but still don't get it. Part of my not getting it is probably related to not understanding the math behind factors. When you say that the total market has value factor but it is canceled out by growth is that because the value premium = return of value - return of growth, and the growth premium = return of growth stocks - return of value stock so therefore the two will cancel each-other out? Maybe I just have to read the book.
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    Re: "Factor investing"

    Post by Morik »

    larryswedroe wrote:Random
    Of course that is true, and it is the growth stocks which dominate the market that are the most susceptible to bubbles. Value by definition isn't, as it's always the 30% cheapest of stocks. All that can happen is that the spread in expected returns between them narrows.
    Larry
    I am curious how the deviation between the the measurements the two poles (large & small, value & growth, etc) in the various factors have changed over time.
    E.g., for the size factor, is the value of MCap<l> - MCap<s>*, is there any correlation with size factor returns, or with anything else of interest?
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    Re: "Factor investing"

    Post by protagonist »

    Taylor Larimore wrote:
    I have also learned from experience (and professor Burton Malkiel) who wrote: "The very popularity of any investment style will sow the seeds of its own destruction." I well remember the popularity of Penny stocks, Day Trading, the "Nifty-Fifty," Dogs of the Dow, IPOs, Commodities, etc..
    My feeling is that Taylor's opinion regarding factor investing is correct.

    That said, according to Wikipedia, Dogs of the Dow has done quite well , and Small Dogs of the Dow has done even better , from the 1920s through 2011. This includes backtesting of the method when O'Higgins first proposed it in 1991, as well as in the 20 years following his proposal of the method. https://en.wikipedia.org/wiki/Dogs_of_the_Dow#Results

    I am not suggesting that Dogs is a way to beat the market in the future, or that its performance necessarily reflects anything besides luck. It is just an interesting observation- I don't know what, if anything, one can conclude from it.

    I also find it interesting that I hear so little about this method these days. It was all over the press back in the 1990s. I even tried it briefly with a small part of my portfolio (and underperformed).
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    Re: "Factor investing"

    Post by larryswedroe »

    Investor guy
    No.

    Try this.

    All factors are LONG/SHORT portfolios.
    So with stocks market beta is long stocks minus the return on one-month Tbills.

    For value factor it's the return on value stocks MINUS the return on growth stocks. So TSM has value stocks, about 30% which gives it a positive exposure to value, the long side. But TSM also owns growth stocks. So that gives it NEGATIVE exposure to value stocks. By definition, TSM will have exactly offsetting + and - exposures to value factor so it's NET exposure is 0.

    Same thing for MOM, size, profitability, quality or any other factor.

    To load on a factor you must have MORE THAN the market's exposure to a factor. So you need more than 10% of the portfolio to be small stocks and more than 30% to be value stocks. If you are less than you have negative exposure to those factors.

    Larry
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    Re: "Factor investing"

    Post by vv19 »

    Duplicate
    Last edited by vv19 on Mon Sep 12, 2016 7:37 pm, edited 1 time in total.
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    Re: "Factor investing"

    Post by vv19 »

    Value if one of the factors, right? Here's the thing, the value index has actually underperformed S&P500 in the last 25 or so years.

    http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

    What should I make of it?
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    Re: "Factor investing"

    Post by larryswedroe »

    Jay,

    25 calendar years ending 2015 FF large value research index returned 10.2, FF small value research index returned 15.0 and S&P returned 9.8

    And for longest time available, implementable live funds, 3/93-7/16 DFA LV outperformed S&P 500 Index (no expenses) 9.9 vs. 9.2 and 4/93- 7/16 DFA SV outperformed it 11.6 to 9.1.

    Larry
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    Re: "Factor investing"

    Post by vv19 »

    OK, so this is more to do with DFA funds vs Vanguard funds, then?

    With all due respect, not everyone has access to DFA funds, nor has any intention of paying their advisors to get access to those funds.
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    Re: "Factor investing"

    Post by lack_ey »

    jay22 wrote:Value if one of the factors, right? Here's the thing, the value index has actually underperformed S&P500 in the last 25 or so years.

    http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D

    What should I make of it?
    You're looking at the Vanguard value index fund vs. the S&P 500. So

    1. There's a difference between a factor and a long-only fund based on a factor. The value factor return is defined by the return differential between high book-to-market stocks and low book-to-market stocks, in the original formulation. These days people may use different value measures but in any case it's long/short. The return of value stocks relative to the market doesn't quite capture the same thing.

    2. An index fund will generally lag its index by a bit because of the expense ratio and trading costs, among other things in the margins (though securities lending can offset this to a degree and occasionally more).

    3. Historically even before this period it was seen that the difference in returns between large value and large growth was smaller than between small value and small growth. Likewise, the difference between large value and large growth smaller than the difference between value overall and growth overall.

    4. Any factor can produce close-to-zero or even negative returns for a couple decades, including the market factor. With large-cap value the expected excess return over the S&P 500 over an average period of time not particularly favoring value or growth especially is not that high to begin with so these things are expected to happen sometimes.

    A few months ago I generated the 2x3 size/BtM total return graphs starting from around the Vanguard fund's inception date, with SCG being small cap growth and SCB being small cap blend and I think the rest is self-explanatory:

    Image

    You have to look at all the data, justifications, etc., and including past existence of excess returns in value in other markets and other asset classes, and decide for yourself what's the likelihood that this was just a relatively weak period by chance vs. value being gone in the future or just a statistical fluke in the past. Could be something in between or something else too.

    jay22 wrote:OK, so this is more to do with DFA funds vs Vanguard funds, then?

    With all due respect, not everyone has access to DFA funds, nor has any intention of paying their advisors to get access to those funds.
    Well, it's in part the difference between 25 years with those exact endpoints vs. the exact period you looked at and the exact one I showed, all of which are slightly different. I think value did better in the year or two prior to the Vanguard fund starting.

    The DFA large value fund had a higher return but also had more risk. In any case see all the above.
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    Re: "Factor investing"

    Post by Random Walker »

    Investor guy,
    I'm not much beyond you, but let me give you my take on the factor thing. The point of the Fama-French work is that the size and value factors are unique and different from the market factor. By looking for example at the return of a portfolio where value stocks are purchased and growth stocks are sold, net exposure to "stocks" (the market factor) is eliminated. It cancels out, isolating the value effect from the market effect. So these long-short portfolios isolate sources of return separate from the market factor. Since most of us are long only investors, we don't see the full factor exposure in our long only funds.

    Dave
    vv19
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    Re: "Factor investing"

    Post by vv19 »

    lack_ey, from your graph, maybe it can inferred that the value premium only shows (substantially) with small caps, then? That is pretty common knowledge. The reason I was comparing value index with S&P500 index was because I wanted to see whether we see a value premium with large caps, too. The result, as you can see, was fairly inconclusive unless, as stated by Larry, you specifically go with DFA funds.
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    Taylor Larimore
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    Growth vs. Value by Jack Bogle

    Post by Taylor Larimore »

    Bogleheads:

    In June,1992, I attended our third Boglehead Conference in Chicago held in conjunction with the annual Morningstar Investment Forum. Mr. Bogle was the main speaker. He made sure that the Bogleheads were given priority seating in the front of the auditorium. His speech was titled, The Telltale Chart. My link at the end contains Mr. Bogle's full speech and the charts he describes. This is what he said about Growth vs. Value:
    I won't belabor those important qualifications of data integrity, risk, and real world costs. But each also comes into play in the next area that I'll consider, value stocks vs. growth stocks. Here, the long-term difference is even more dramatic than small vs. large: The annual return since 1928 is reported as 12.2% for large-cap value stocks and 9.6% for large-cap growth stocks, a difference of fully 2.6 percentage points. The compounding of those returns results in a stunning chasm in the final value of an initial dollar: Value $5,100, Growth $900. Again, higher risk (standard deviation of value was 27%, vs. 20% for growth) accounts for much of the gap, but even the increased risk-adjusted return of 11.2% for growth stocks falls one percentage point short of the value outcome. The data are so impressive that one wants simply to say: Case closed!

    But now let's turn to our telltale chart and carefully examine the record. While the RTM is hardly as clear as its earlier counterpart, we can observe some significant things going on. Curiously, during the first 27 years (!), not much happens. Growth wins by a bit in the first 12 years, value in the next 11, after which both series deliver about the same annual returns through 1961 (16%). Value leads again through 1968, and after a four-year hiatus rises again through 1977, pauses for four years, and then surges through 1988. Then comes the heft of the great bull market, with growth leading value fairly consistently and by a wide margin (21% vs. 16% annually) through 1999. That sharp dichotomy was then followed by the sharpest mean reversion in market history, with growth toppling by -28% in 2000-2001, with value off less than 1%. RTM strikes again! But, perhaps surprisingly, over the entire period 1984-2001, growth (15.3% per year) retains a fragile grip on its leadership over value (14.4%).

    The data I've shown you, of course, represent the statistical reconstruction of market sector returns. So, I'd now like to examine not abstract portfolios, but growth and value mutual funds that operate in the real world. The data are available from 1937, and the general patterns parallel those of the French-Fama study, but with a curious dichotomy. While the average annual return of the growth mutual funds (11.6%) during this long period actually exceeded the French-Fama large-cap growth stocks (11.2%), the value mutual fund return of 11.0% fell far below that of French-Fama value return of 15.2%, perhaps because the Fama-French value portfolio has a risk fully 45% above the value funds. Nonetheless, the French-Fama combined growth and value returns exceed the combined fund returns by 1.9% per year, a pretty good approximation of the costs that mutual funds incur. So investors should not ignore the obvious costs of implementing a strategy that rises, pristinely, out of academic studies that cannot be precisely replicated in the real world.

    The reason for the dichotomy between these markedly different sets of growth fund and value fund relative returns may rest on the fact that value managers invest less on the basis of the statistical criteria that sector indexes use to differentiate growth stocks from value stocks (usually price-to-book-value) and more on other factors. But in any event, the validity of the growth and value index statistics rests on the soundness of the indexes used in measuring the sectors they purport to represent. Consider, for example, the S&P/Barra Growth Index. Based on relative price-to-book ratios, this Index categorizes 50% of the weight of the S&P 500 Index as growth stocks. When their prices soared during the 1990s, the number of growth stocks in the index tumbled from 220 to 106 in 1999—114 erstwhile growth stocks were unceremoniously shoved into the Value Index. Then, when growth stocks stumbled, 51 "value" stocks returned to the Growth Index, bringing the present total to 157—and rising! With the huge asset write-downs we're currently seeing, many former growth stocks are now defined as value stocks. So differences in both management costs and index composition should make us extremely cautious about the application of abstract data to the real world.

    In any event, place me squarely in the camp of the contrarians who don't accept the inherent superiority of value strategies over growth strategies. I've been excoriated for my views, but I'm comforted by this reported exchange between Dr. Fama and a participant at a recent investment conference: "What do you say to otherwise intelligent people like Jack Bogle who examine this same data and conclude that there is no size or value premium?" His response: "How far are they from the slide? If I get far enough away, I don't see it either . . . Whether you decide to tilt towards value depends on whether you are willing to bear the associated risk . . . The market portfolio is always efficient . . . For most people, the market portfolio is the most sensible decision." Amen!
    The Telltale Chart

    Best wishes.
    Taylor
    "Simplicity is the master key to financial success." -- Jack Bogle
    lack_ey
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    Re: "Factor investing"

    Post by lack_ey »

    jay22 wrote:lack_ey, from your graph, maybe it can inferred that the value premium only shows (substantially) with small caps, then? That is pretty common knowledge. The reason I was comparing value index with S&P500 index was because I wanted to see whether we see a value premium with large caps, too. The result, as you can see, was fairly inconclusive unless, as stated by Larry, you specifically go with DFA funds.
    That's since about the inception of Vanguard's fund. Over longer history, a different story:

    Image

    Data is from the French (Kenneth French, Fama's coauthor) data library as before. These are gross returns so honestly in the small caps the returns would be lower because of real-world transaction costs. Also to the extent that there is some effect from market inefficiencies particularly in the past or some issues with the data, that is probably lower now.

    You can also check in other countries too. Some summary stats in various sources. See for example "Value and Momentum Everywhere", though not a breakdown between large value vs. small value.

    Taylor Larimore wrote:Bogleheads:

    In June,1992, I attended our third Boglehead Conference in Chicago held in conjunction with the annual Morningstar Investment Forum. Mr. Bogle was the main speaker. He made sure that the Bogleheads were given priority seating in the front of the auditorium. His speech was titled, The Telltale Chart. My link at the end contains Mr. Bogle's full speech and the charts he describes. This is what he said about Growth vs. Value:

    -quote-
    The Telltale Chart

    Best wishes.
    Taylor
    As mentioned many times before, the data from active managers has some issues with not really fitting cleanly in styles, style drift, etc. Some data issues and it doesn't quite answer the question people are interested in here. Also probably represents active managers in the aggregate tending to avoid the worst parts of the growth market, the names that too often sucked in the retail investors. It's something to keep in mind but not all that conclusive.
    kolea
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    Re: "Factor investing"

    Post by kolea »

    lack_ey wrote: 1. There's a difference between a factor and a long-only fund based on a factor. The value factor return is defined by the return differential between high book-to-market stocks and low book-to-market stocks, in the original formulation. These days people may use different value measures but in any case it's long/short. The return of value stocks relative to the market doesn't quite capture the same thing.
    Excuse my ignorance here. By "Long-Short" I take that to mean you are buying value for long term holding in the portfolio and removing growth from the portfolio. But that sounds exactly how a value fund is constructed, yes? What am I missing here? How do you actualize a "return differential between high book-to-market stocks and low book-to-market stocks" into a real portfolio?
    Kolea (pron. ko-lay-uh). Golden plover.
    lack_ey
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    Re: "Factor investing"

    Post by lack_ey »

    kolea wrote:
    lack_ey wrote: 1. There's a difference between a factor and a long-only fund based on a factor. The value factor return is defined by the return differential between high book-to-market stocks and low book-to-market stocks, in the original formulation. These days people may use different value measures but in any case it's long/short. The return of value stocks relative to the market doesn't quite capture the same thing.
    Excuse my ignorance here. By "Long-Short" I take that to mean you are buying value for long term holding in the portfolio and removing growth from the portfolio. But that sounds exactly how a value fund is constructed, yes? What am I missing here? How do you actualize a "return differential between high book-to-market stocks and low book-to-market stocks" into a real portfolio?
    By "long/short" I mean holding one group of stocks and short selling the other group. Not "long" as in the length of time of holding but "long" as in the opposite of short selling.

    There are some funds, factor-based and otherwise, that sell stocks short. You could do it yourself if you really wanted. In the real world there would be costs associated with this and other issues.

    The academic factor definitions are more a construction to aid in analyzing and describing things rather than a blueprint for something you'd want to actually do, though. The point is just that you have to be careful about the way things are defined if you're going to look at what the factor returns were.

    You can achieve factor tilts without shorting anything, in any case. If you own more value stocks than the market and less growth stocks than the market, this is akin to owning the market plus a pure long/short value fund, minus all the costs. Fama and French themselves argue against running actual long/short portfolios in funds (see this piece), and DFA doesn't offer any. That said, if you wanted very high non-market factor exposures relative to market, particularly if non-size, and even more particularly if going for multiple factors, you would have to go short. DFA offers mostly just size and value (mild profitability component in value nowadays, screening out momentum nowadays to reduce negative momentum too), so no particular need to go there.

    There's an ETF that actually runs a long/short value portfolio, QuantShares US Market Neutral Value Fund (CHEP). Hasn't exactly caught on. Some hedge funds do some of these things in part. Market neutral mutual funds run long/short stock portfolios but most do more discretionary rather than systematic factor-based investing or simply some non-traditional-factor-based quant stuff, and the ones explicitly targeting factors probably use multiple factors (see for example AQR).
    bjr89
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    Re: "Factor investing"

    Post by bjr89 »

    -----
    Last edited by bjr89 on Fri Nov 16, 2018 7:05 pm, edited 1 time in total.
    larryswedroe
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    Re: "Factor investing"

    Post by larryswedroe »

    jay
    There are many low cost ETFs that provide more exposure to factors than Vanguard index funds.
    Also as noted the value premium is much larger in small than large

    I would also add that today trading costs in small caps especially for patient algorithmic traders willing to accept tracking error risk (so not pure indexing) is extremely low. One fund we work with told me that about 80% of their buys are now below the mid point of the bid/offer spread.

    And study on AQR's live trading costs found that their live costs were small fraction of the costs estimated in the literature, and that's due to patient trading

    Larry
    longinvest
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    Re: "Factor investing"

    Post by longinvest »

    The main motivation of our mentor Jack Bogle to start the first publicly available index fund was not the "efficiency" of total-market indexing; it was the simpler fact that it was a cheap way (due to its minimal turnover*) to harvest the returns of the market. This is what he called the "Cost Matters Hypothesis". History has proven him right and continues to do so.

    * Minimal turnover leads to fewer transactions which translates into less losses (relative to the market) due to transaction fees (visible), taxes on capital gains (semi-visible), and spreads (hidden).

    For investors, there's something very comforting to be able to look at a Total Market index and see that his fund is tracking it very closely, given that the fund's day-to-day operations are quite opaque (e.g. how does it manage to stay in balanced despite all the subscriptions and redemptions).

    The only factor which can easily be invested into is the total market ("beta").

    Total-market investing requires very little ongoing trading, and more importantly, there's little differences between definitions of what makes the total market. For example, some total-market index might include micro-caps or not; this represents a difference of less than 2%. There might be small differences in the definition of "free-float" or other inclusion criteria at the margin of investable stocks (e.g. buy stocks at their initial public offering or not? When to get rid of a penny stock?). Charts of the real-life growth of different well-managed low-cost funds tracking total market indices show practically no differences (e.g. there's no significant difference between Vanguard's and Fidelity's total-market fund results).

    Other factors, like value and small, can only be invested directly into when a fund does 2 things: it invest long into value or small stocks, and it shorts growth or large stocks, as if shorting was an easy thing to do (it's not, because you have to find another investor willing to lend you the stock to short) or free (it's obviously not, because the few investors who will lend you their stocks to short will charge you dearly for it). The worst part of it is that nobody seems to agree on the definition of what is a value stock, in the first place! Is book/price ratio the right definition?

    Author Larry Swedroe, who published books about factors, wrote earlier in this thread that even FF don't recommend investing directly into a long/short fund. So, you end up with some weird definition of a value fund, which provides a hazy and probably unstable, given the dynamics of the market, exposure to a market factor. DFA funds, for example, don't even track an index, so you won't know if they have a tracking error. That's paradise for the fund manager, as he doesn't have to match a benchmark. Even better, DFA keeps part of its costs outside the ER by cleverly hiding them into advisor fees, as these funds are not available without paying for an advisor (or through workplace plans where the fess can be hidden). This helps keeping a part of the ongoing costs outside of comparative charts. That's really, really clever!

    Back to the hazy definitions: Apparently, some real-life funds have been more "valuey" than others. Even some of the few beloved "index" factor funds such as PXSV, on this forum (Due diligence on RAFI Pure Small Value), don't seem to be able to stick to their choice of index, sometimes making controversial changes (PXSV has changed indexes).

    Author Larry Swedroe has been suggesting, on the forums, to invest into high-cost AQR offerings to get exposure to multi-factor funds, where the funds do provide a long/short exposure, but where the factor exposure is under ongoing change, based on the "taste" of the managers and whatever new factor is discovered. These are completely opaque funds doing all kinds of trading with no index whatsoever to track. One has to have utterly total faith into the fund manager and his traders when investing in such funds. There will be no way to compare the outcome to anything, as apparently we should never "confuse strategy with outcome" according to author Larry Swedroe. The outcome could be either marvelous or disastrous, yet no simple investor like me will ever be able to know if it was due to luck, bad luck, cleverness/dumbness of the traders, or having succeeded to exactly match the followed factors, specially that the factor exposure is neither clearly disclosed (before hand) or even stable.

    So, in summary, investing in anything other than the total market is making a huge leap of faith that the fund manager has made the "right" choice of factor definition (e.g. what is value?), partial factor exposure (for funds using long-only investments), that costs won't kill all benefits (for funds shorting stocks), and that one is not being fleeced by traders on the other side of the fund's ongoing transactions (higher turnover). It is really difficult for me to picture these investments as anything other than active management, under any reasonable definition of "active" and "passive".
    Variable Percentage Withdrawal (bogleheads.org/wiki/VPW) | One-Fund Portfolio (bogleheads.org/forum/viewtopic.php?t=287967)
    protagonist
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    Re: "Factor investing"

    Post by protagonist »

    longinvest wrote:The main motivation of our mentor Jack Bogle to start the first publicly available index fund was not the "efficiency" of total-market indexing; it was the simpler fact that it was a cheap way (due to its minimal turnover*) to harvest the returns of the market. This is what he called the "Cost Matters Hypothesis". History has proven him right and continues to do so.

    * Minimal turnover leads to fewer transactions which translates into less losses (relative to the market) due to transaction fees (visible), taxes on capital gains (semi-visible), and spreads (hidden).

    For investors, there's something very comforting to be able to look at a Total Market index and see that his fund is tracking it very closely, given that the fund's day-to-day operations are quite opaque (e.g. how does it manage to stay in balanced despite all the subscriptions and redemptions).

    The only factor which can easily be invested into is the total market ("beta").

    Total-market investing requires very little ongoing trading, and more importantly, there's little differences between definitions of what makes the total market. For example, some total-market index might include micro-caps or not; this represents a difference of less than 2%. There might be small differences in the definition of "free-float" or other inclusion criteria at the margin of investable stocks (e.g. buy stocks at their initial public offering or not? When to get rid of a penny stock?). Charts of the real-life growth of different well-managed low-cost funds tracking total market indices show practically no differences (e.g. there's no significant difference between Vanguard's and Fidelity's total-market fund results).

    Other factors, like value and small, can only be invested directly into when a fund does 2 things: it invest long into value or small stocks, and it shorts growth or large stocks, as if shorting was an easy thing to do (it's not, because you have to find another investor willing to lend you the stock to short) or free (it's obviously not, because the few investors who will lend you their stocks to short will charge you dearly for it). The worst part of it is that nobody seems to agree on the definition of what is a value stock, in the first place! Is book/price ratio the right definition?

    Author Larry Swedroe, who published books about factors, wrote earlier in this thread that even FF don't recommend investing directly into a long/short fund. So, you end up with some weird definition of a value fund, which provides a hazy and probably unstable, given the dynamics of the market, exposure to a market factor. DFA funds, for example, don't even track an index, so you won't know if they have a tracking error. That's paradise for the fund manager, as he doesn't have to match a benchmark. Even better, DFA keeps part of its costs outside the ER by cleverly hiding them into advisor fees, as these funds are not available without paying for an advisor (or through workplace plans where the fess can be hidden). This helps keeping a part of the ongoing costs outside of comparative charts. That's really, really clever!

    Back to the hazy definitions: Apparently, some real-life funds have been more "valuey" than others. Even some of the few beloved "index" factor funds such as PXSV, on this forum (Due diligence on RAFI Pure Small Value), don't seem to be able to stick to their choice of index, sometimes making controversial changes (PXSV has changed indexes).

    Author Larry Swedroe has been suggesting, on the forums, to invest into high-cost AQR offerings to get exposure to multi-factor funds, where the funds do provide a long/short exposure, but where the factor exposure is under ongoing change, based on the "taste" of the managers and whatever new factor is discovered. These are completely opaque funds doing all kinds of trading with no index whatsoever to track. One has to have utterly total faith into the fund manager and his traders when investing in such funds. There will be no way to compare the outcome to anything, as apparently we should never "confuse strategy with outcome" according to author Larry Swedroe. The outcome could be either marvelous or disastrous, yet no simple investor like me will ever be able to know if it was due to luck, bad luck, cleverness/dumbness of the traders, or having succeeded to exactly match the followed factors, specially that the factor exposure is neither clearly disclosed (before hand) or even stable.

    So, in summary, investing in anything other than the total market is making a huge leap of faith that the fund manager has made the "right" choice of factor definition (e.g. what is value?), partial factor exposure (for funds using long-only investments), that costs won't kill all benefits (for funds shorting stocks), and that one is not being fleeced by traders on the other side of the fund's ongoing transactions (higher turnover). It is really difficult for me to picture these investments as anything other than active management, under any reasonable definition of "active" and "passive".
    +1. Excellent explanation. Thank you.

    Refer to Nisiprius' evaluation here: viewtopic.php?f=10&t=199307

    Ultimately I think it comes down to the old, inescapable relationship between potential reward and risk. (In finance, sports, employment, love, you name it *laughing*)
    Last edited by protagonist on Tue Sep 13, 2016 9:04 am, edited 2 times in total.
    Random Walker
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    Re: "Factor investing"

    Post by Random Walker »

    Long invest,
    Perhaps I am a bit naive, but I think parts of your post are incorrect and too cynical. Regarding DFA. The advisors are separate from the fund company and the fund company does not in any way benefit from the advisor fee that I know of. The DFA funds are formulaic passive. There is no market timing or active stock selection. I believe the traders are agnostic to the specific stocks; they just buy, sell, hold according to structured rules based on market cap, P/B, momentum, profitability. Although they are not following an external index, the funds are sort of their own internal indexes.
    Yes, one is to some extent going on faith when they choose the advisor/ DFA route. That decision though, should be based on a fair amount of understanding and information as well. The separate nature of the advisor from the fund company is crucial. The advisor needs to have a fiduciary standard to do what is best for the client. That means the advisor is not committed exclusively to DFA. They will use another fund company if they deem its product better for the client at the time.
    It's like buying a used car. The more informed the customer is about what he is getting and not getting, the more likely he is to be satisfied. I think William Bernstein once said something to the effect that once an investor knows enough to choose a good advisor, he can likely take care of the investing himself. Even under that circumstance, there can be very good reasons to go the advisor route. There is zero reason to choose an advisor who does not commit to fiduciary standard.

    Dave
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    Taylor Larimore
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    "Investing in Total Markets"

    Post by Taylor Larimore »

    Bogleheads:

    In 2002, John Norstad, an academic at Northwestern University, wrote a very informative article about how to invest successfully and the reasons for investing in total market index funds:

    INVESTING IN TOTAL MARKETS

    Best wishes.
    Taylor
    Last edited by Taylor Larimore on Tue Sep 13, 2016 9:28 am, edited 1 time in total.
    "Simplicity is the master key to financial success." -- Jack Bogle
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