After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

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Random Walker
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After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Random Walker » Sun Oct 22, 2017 9:58 am

It seems the factor talk has declined quite a bit recently. Market beta has had a great 8 year run. With P/E ratios very high and interest rates very low, I’m wondering if any Bogleheads are increasing their interest in diversifying across other potential sources of return: cross sectional Momentum, Time series Momentum, value, size, profitability, alternatives?
Myself, at age 55, recently took a lot of risk off the table and decreased my equity allocation lots. At the same time, I increased my tilt to size and value on the equity side and added positions in alternative lending, Style Premia, TS Momentum, reinsurance, and Variance risk premium. The cost of the portfolio has increased on two fronts: increased expense ratios and likely much more significantly much less tax efficient. I’m trading these increased costs for improved portfolio efficiency. By my guesstimates my 42%equities/38%bonds/20%alternatives portfolio has the same after tax expected return as a 85%equities/15% bonds TSM portfolio with a lower SD and a much lower potential maximum bear market loss. I believe my portfolio has and SD of about 12ish compared to about 15ish for the 85/15 TSM and a 50% decline in the equity markets would probably cause a 35-40% loss in the TSM portfolio versus 15-20% loss in my portfolio.
There are no free lunches in investing. After one has seen the passive light, portfolio improvements are evolutionary and incremental, not revolutionary. And improvements come at increased cost. The costs are certain and the improvements only potential. Interested to hear discussion.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nedsaid » Sun Oct 22, 2017 10:32 am

Steady as she goes, I have not made major changes to my portfolio. I keep harvesting gains from my US Stocks in small increments and have allowed my International Stock allocation to drift upwards. I keep adding to bonds in small increments as I sell US Stocks. So my allocation to stocks remains at almost 67%. My portfolio has a Large Value and Small Value tilt. Small Caps 16% of portfolio vs. 9% for US Total Market Index. My earnings and price momentum funds are doing okay but not setting the world on fire now. In recent months, I bought two deep value stocks, Gilead Sciences and Ford.

We are in a Large Growth market and have been since the 2008-2009 financial crisis save for 2016 which was a great Value year. 2017 has seen a return to Large Growth leading the market. Low Volatility seems to have cooled off. So what does that leave other than beta? My suspicion is that Profitability/Quality is leading in this market and possible momentum. Size, Value, Low Volatility don't seem to be doing so well now.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Sandtrap » Sun Oct 22, 2017 10:43 am

nedsaid wrote:
Sun Oct 22, 2017 10:32 am
Steady as she goes, I have not made major changes to my portfolio. I keep harvesting gains from my US Stocks in small increments and have allowed my International Stock allocation to drift upwards. I keep adding to bonds in small increments as I sell US Stocks. So my allocation to stocks remains at almost 67%. My portfolio has a Large Value and Small Value tilt. Small Caps 16% of portfolio vs. 9% for US Total Market Index. My earnings and price momentum funds are doing okay but not setting the world on fire now. In recent months, I bought two deep value stocks, Gilead Sciences and Ford.

We are in a Large Growth market and have been since the 2008-2009 financial crisis save for 2016 which was a great Value year. 2017 has seen a return to Large Growth leading the market. Low Volatility seems to have cooled off. So what does that leave other than beta? My suspicion is that Profitability/Quality is leading in this market and possible momentum. Size, Value, Low Volatility don't seem to be doing so well now.
This has me concerned, opportunity cost, watching potential gains going out the window. Staying the course and adhering to one's allocation and AA is tough. I've experienced this before. Sticking to my niche market, keeping rents low, while R/E booms around me. Tough.
As to the OP's question, I consider it every day, but don't do anything :( .. . . . so far.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nisiprius » Sun Oct 22, 2017 10:47 am

The "market" factor is not just another factor like the others. Although it's an idealization and an oversimplification, I can see obvious, convincing reasons why stocks ought to make money--they are an indirect claim on business profits. I can see obvious reasons why bonds ought to make money--they are legal contracts with the bond issuer. And I can see obvious reasons why stocks should have both higher risk and higher return than bonds (you are participating in how well the business does, with a corporate bond you are only gambling on whether or not the company can stay in business at all).

The other factors are quite different. To begin with, you can invest in the market factor with a long-only portfolio. (Not quite all, but almost all of Vanguard's funds are long-only). You can't invest in any other factor except as a long-short portfolio. The other factors aren't really things in themselves, they are explanations after the fact of differences between categories of stocks. Furthermore, after you take that difference there isn't a whole lot of the factor there, so you need to leverage it up to have enough to be worthwhile. This is of course just what many of AQR's funds do, and they of course have an explanation of why what they're doing isn't risky, they know what they're doing, and the risk is under control. But there has never been a crash or collapse or crisis that didn't involve leverage, and the people in it always thought they knew what they were doing. Indeed, the hedge fund managed by Cliff Asness of AQR experienced a terrible crash in 2007. The question to be asked is: what exactly was Asness saying about the risk and safety of the short positions and leverage he was using back then?

Of course, you can add small amounts of selected factors to a long-only stock portfolio by tilting and concentrating. One homely analogy is that a total market investor's portfolio is like an iron bar, and a factor-aware investors could be like a tube with more strength for the same weight because the material is concentrated around the edges instead of evenly distributed across the cross-section. However, it is just a tweak. The people who promote these things make a big deal out of it, but even if you accept it, it is not qualitatively different. You're not "diversifying across risk factors" by very much. It's just fine tuning, a tweak, an "edge."

The other thing that makes the other factors different is that it is not quite easy to see just why or how they should make money. I know why real estate makes money--people are willing to pay to live in a house. But does "momentum" have a deserved return? Does "momentum" itself do something useful or earn dividends? I don't think so. I think that at best "momentum" is a number that lets you outpsych other investors and take money away from other investors. It is (said to be) a mathematical formula for winning at rock-paper-scissors. Invest according to the calculated factors and you will consistently leach away money from other investors who invest based on gut feeling, and buy a stock because it is going up.

In short, I think it's sophistry to say "here are all these factors. You are only investing in one, shouldn't you diversify into the others?" It puts the zoo of factors onto a false equal footing with "the market portfolio" consisting of everything traded on the stock market. And it also puts a zoo of "alternatives" onto a false equal footing with traditional securities.
Look, all you are buying in the supermarket is "food." Don't you think you should be diversifying into motor oil, fidget spinners, and romance novels?
Last edited by nisiprius on Sun Oct 22, 2017 8:02 pm, edited 1 time in total.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nedsaid » Sun Oct 22, 2017 10:52 am

Sandtrap wrote:
Sun Oct 22, 2017 10:43 am
nedsaid wrote:
Sun Oct 22, 2017 10:32 am
Steady as she goes, I have not made major changes to my portfolio. I keep harvesting gains from my US Stocks in small increments and have allowed my International Stock allocation to drift upwards. I keep adding to bonds in small increments as I sell US Stocks. So my allocation to stocks remains at almost 67%. My portfolio has a Large Value and Small Value tilt. Small Caps 16% of portfolio vs. 9% for US Total Market Index. My earnings and price momentum funds are doing okay but not setting the world on fire now. In recent months, I bought two deep value stocks, Gilead Sciences and Ford.

We are in a Large Growth market and have been since the 2008-2009 financial crisis save for 2016 which was a great Value year. 2017 has seen a return to Large Growth leading the market. Low Volatility seems to have cooled off. So what does that leave other than beta? My suspicion is that Profitability/Quality is leading in this market and possible momentum. Size, Value, Low Volatility don't seem to be doing so well now.
This has me concerned, opportunity cost, watching potential gains going out the window. Staying the course and adhering to one's allocation and AA is tough. As to the OP's question, I consider it every day, but don't do anything :( .. . . . so far.
I don't blame you for holding tight. Many asset classes out there look expensive: US Stocks, US Bonds, Developed Market Bonds, Gold. Cheaper asset classes are Developed Market Stocks and Emerging Markets Stocks which are outright cheap. A case could be made for commodities, particularly oil but that is fraught with risk. I have beat the drums for Large US Value stocks but no one and particularly the markets seem to be listening. The counter argument to Value is Momentum. Hot stocks and hot asset classes can remain hot for a long time. Indeed, momentum is the bane of Value investors as Value is associated with negative momentum.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nisiprius » Sun Oct 22, 2017 10:55 am

P.S. to put it another way, just grabbing something from Wikipedia,
The Fama–French three-factor model explains over 90% of the diversified portfolios returns, compared with the average 70% given by the CAPM (within sample).
Of course, "within sample" means "in the past." But on the face of it, that's the claim for factors.

You can do this glass-70%-full or glass-30%-empty.

Incidentally, if the three-factor model explains over 90% of portfolio returns, how much is left for all the other new! improved! factors do? ("Now includes secret miracle ingredient, MOM!") But perhaps it turns out that the past behavior "within sample" wasn't borne out going forward "out of sample."

(Notice, this does not mean that a total market stock fund captures only 70% of returns. It just means that if you look at a large group of stocks in hindsight, you can match their past behavior with 70% accuracy just by saying "hey! they're stocks!" and you can increase that to 90% by saying "hey! they're small growth stocks!")
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by avalpert » Sun Oct 22, 2017 11:01 am

nisiprius wrote:
Sun Oct 22, 2017 10:47 am
The "market" factor is not just another factor like the others. Although it's an idealization and an oversimplification, I can see obvious, convincing reasons why stocks ought to make money--they are an indirect claim on business profits. I can see obvious reasons why bonds ought to make money--they are legal contracts with the bond issuer. And I can see obvious reasons why stocks should have both higher risk and higher return than bonds (you are participating in how well the business does, with a corporate bond you are only gambling on whether or not the company can stay in business at all).

The other factors are quite different. To begin with, you can invest in the market factor with a long-only portfolio. (Not quite all, but almost all of Vanguard's funds are long-only). You can't invest in any other factor except as a long-short portfolio. The other factors aren't really things in themselves, they are explanations after the fact of differences between categories of stocks. Furthermore, after you take that difference there isn't a whole lot of the factor there, so you need to leverage it up to have enough to be worthwhile. This is of course just what many of AQR's funds do, and they of course have an explanation of why what they're doing isn't risky, they know what they're doing, and the risk is under control. But there has never been a crash or collapse or crisis that didn't involve leverage, and the people in it always thought they knew what they were doing. Indeed, the hedge fund managed by Cliff Asness of AQR experienced a terrible crash in 2007. The question to be asked is: what exactly was Asness saying about the risk and safety of the short positions and leverage he was using back then?

Of course, you can add small amounts of selected factors to a long-only stock portfolio by tilting and concentrating. One homely analogy is that a total market investor's portfolio is like an iron bar, and a factor-aware investors could be like a tube with more strength for the same weight because the material is concentrated around the edges instead of evenly distributed across the cross-section. However, it is just a tweak. The people who promote these things make a big deal out of it, but even if you accept it, it is not qualitatively different. You're not "diversifying across risk factors" by very much. It's just fine tuning, a tweak, an "edge."

The other thing that makes the other factors different is that it is not quite easy to see just why or how they should make money. I know why real estate makes money--people are willing to pay to live in a house. But does "momentum" have a deserved return? Does "momentum" itself do something useful or earn dividends? I don't think so. I think that at best "momentum" is a number that lets you outpsych other investors and take money away from other investors. It is (said to be) a mathematical formula for winning at rock-paper-scissors. Invest according to the calculated factors and you will consistently leach away money from other investors who invest based on gut feeling, and buy a stock because it is going up.

In short, I think it's sophistry to say "here are all these factors. You are only investing in one, shouldn't you diversify into the others?" It puts the zoo of factors onto a false equal footing with "the market portfolio" consisting of everything traded on the stock market. And it also puts a zoo of "alternatives" onto a false equal footing with traditional securities.

Look, all you are buying in the supermarket is "food." Don't you think you should be diversifying into motor oil, fidget spinners, and romance novels?
Given the rest of your reasoning here isn't that last question disingenuous? I mean, I can explain why food is helpful in providing me nutrients and energy but I can't even pretend that motor oil, fidget spinners and romance novels can contribute to that in any way.

What this boils down to is you don't believe that other risk factors have compelling explanations for why the market should reward them - it isn't as though there aren't explanations out there with peer-reviewed academic analysis to defend them. I find some compelling and some not, in soft-sciences like finance differences of opinion here are to be expected (heck, even in the hard sciences finality is never final and what everyone knew to be true can and has been found false).

To take back to your last question - if I wanted to be equally disingenuous I would suggest you are only looking at calories when buying food, don't you think you should ensure a balance of vitamins and minerals as well? (and we can then let nutritional scientists have the same disagreements over which ones actually matter)...

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nedsaid » Sun Oct 22, 2017 11:08 am

nisiprius wrote:
Sun Oct 22, 2017 10:47 am

The other factors are quite different. To begin with, you can invest in the market factor with a long-only portfolio. (Not quite all, but almost all of Vanguard's funds are long-only). You can't invest in any other factor except as a long-short portfolio.
Nedsaid: I see your point but I think your comment should be more precise. In theory, the best way to invest with factors would be with long/short portfolios but it can be done less efficiently long only. For example, if you go long only with momentum you need liquidity and that puts you in the Large Growth area of the market. You need liquidity so you get out quickly without the bid/ask spreads eating up your profits. Shorting is hard to do with smaller stocks thus the limits to arbitrage that Larry Swedroe talks about.

Value can be done long only as can Size as can Low Volatility. Long only strategies are pretty much beta plus factor. If you do factor only in a market neutral fund, taking out beta, then you need to leverage to get beta like returns.

nisiprius wrote:
Sun Oct 22, 2017 10:47 am
In short, I think it's sophistry to say "here are all these factors. You are only investing in one, shouldn't you diversify into the others?" It puts the zoo of factors onto a false equal footing with "the market portfolio" consisting of everything traded on the stock market. And it also puts a zoo of "alternatives" onto a false equal footing with traditional securities.

Look, all you are buying in the supermarket is "food." Don't you think you should be diversifying into motor oil, fidget spinners, and romance novels?

Nedsaid: No, it is not sophistry. Beta explains maybe 2/3 or 3/4 of market returns. A good example was that high volatility stocks had less return than predicted by the CAPM (Capital Asset Pricing Model) and low volatility stocks had more return than predicted. So clearly, something else was at work here. Hence the search for factors that explained more of the market return. With beta, size, value, momentum, profitability/quality, and low volatility; we are up to about 96%.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by garlandwhizzer » Sun Oct 22, 2017 2:47 pm

What I have been doing recently is acting my age for a change. I am 70, have been retired for 20 years, and as of last year still had a portfolio that was 66% equity and 34% bonds, some beta sand some factor in equity. I am now at a point in life where the uncertainty of risk outweighs the potential for increased expected gains from that risk. I am now ready to start a modest glide path that increases bonds and decreases stocks, lowering my overall portfolio risk. It's about time. Good news is that I've been lucky overall and been fully on board the equity train for several exuberant bull equity markets over the last 30 years. Make no mistake about it, IMO the sheer luck of when you start investing and when you stop is more important to investor returns than skill, or factors, or anything else.

The problem for those of us who are seniors is that life expectancy is increasingly important issue as we age. Maybe I'll live to 100, maybe just to 75. A real question arises: do I have time for equity and/or factor risk to be rewarded? Or should I accept lower expected returns but greater certainty of avoiding substantial loss with bonds? I have always been equity heavy, 100% early along, but now as my time horizon shortens I see more and more the benefits of bond exposure. I'm still not 60/40 but will get close to that after New Years. Belatedly I am starting a modest glide path. I think by far the most important question in portfolio construction is how much in equity and how much in bonds. Whether to employ beta alone, beta plus factors, factors alone, or alternates is IMO less critical than the equity/bond mix. Good arguments can be made for any of those equity approaches but potential disasters may await those who either have too much in equity or not enough.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Random Walker » Sun Oct 22, 2017 3:56 pm

GarlandWhizzer,
You wrote
I am now ready to start a modest glide path that increases bonds and decreases stocks, lowering my overall portfolio risk. It's about time. Good news is that I've been lucky overall and been fully on board the equity train for several exuberant bull equity markets over the last 30 years. Make no mistake about it, IMO the sheer luck of when you start investing and when you stop is more important to investor returns than skill, or factors, or anything else.
Given your age and current valuations, why not make an abrupt change to the less risky AA you want rather than the modest glide path? Better you rebalance on your terms and pay tax than have the market rebalance for you.

Also, you mention that at your age you wonder if there will be enough time for the factors to show their benefit. I would contend that the shorter the time horizon, possibly the more valuable factor diversification. Over short periods of time we don’t know what each of the factors, including the market factor, is going to do. Diversifying across factors may be even more useful over short periods. Curious to hear your thoughts.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by packer16 » Sun Oct 22, 2017 4:33 pm

I think to the question is yes but how resilient are the factors you are using. The ones that have an economic versus correlation basis IMO are the most reliable. The economic ones are bonds, stocks & re-insurance risk. I look at P-to-P as a fancy way to provide high yield credit to folks who cannot get credit from more traditional & conservative underwriting sources. Once you determine the fundamental economic factors, you then can try to find the lowest cost securities that provide that exposure. IMO many of these new products get the first part right but then folks are willing to pay high fees to get questionable excess benefit for so-called "pure" products.

I personally like the securities that are more like bonds in their cash flow characteristics but are priced as real estate or stocks. These include asset like NNN real estate, ship leasing, aircraft leasing & infrastructure. There are low fee alternatives in this space.

I also like the re-insurance idea but IMO you pay a very high price for pure exposure versus exposure via some of the best risk managers in the world with some conservative equity risk. The 2 I like are BRK & MKL. The equity exposure more than pays for the costs & actually adds to the value of these re-insurance products. The one aspect of re-insurance/insurance I have heard from those in the field is there is a time to be exposed & a time to not be exposed based upon the pricing of the insurance. The re-insurance funds (SRRIX) do not have a choice but to be exposed all the time which IMO is a structural disadvantage. This is similar to high-yield bonds. There are times to be exposed & times to stay away.

The one point about the statement that factors explain 90% of security returns is true only in the past. If this was even true by significant margin over 50% in the future, the factors funds would be able to beat the pants off any other fund out there & this is not the case. Depending upon your time horizon these factors may only add risk with no return as the return they add is diversifiable.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by whodidntante » Sun Oct 22, 2017 4:49 pm

Random Walker wrote:
Sun Oct 22, 2017 9:58 am
With P/E ratios very high and interest rates very low, I’m wondering if any Bogleheads are increasing their interest in diversifying across other potential sources of return: cross sectional Momentum, Time series Momentum, value, size, profitability, alternatives?
Yes I have. I started a thread about it a while back. I did not add a ton of beta neutral exposure but I did add a bit through two AQR funds. And I've added to my long-only factor exposure.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by baw703916 » Sun Oct 22, 2017 5:07 pm

Well, ideally I'd like my portfolio to have a lot of alpha! :wink: :beer :moneybag
Most of my posts assume no behavioral errors.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by snarlyjack » Sun Oct 22, 2017 5:13 pm

GarlandWhizzer,

Far be it from me, to give advice to you but in studying
some millionaires next door types (The Janitor Next Door,
Ronald Read & The Walgreens Millionaire).

Ronald Read had a AA of 75/25 (75% stocks, 25% cash)
he lived until he was 92. The Walgreens Millionaire held
Walgreens stock for decades. He was still alive at age 96,
when he gave his Walgreens stock to the Audubon Society.

They might say your still a "youngster"...Thank you for all your help. :sharebeer

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by TD2626 » Sun Oct 22, 2017 6:38 pm

Is it possible that returns from factors are simply explained by excess risk? For example, some could argue that small cap stocks are more risky and therefore over the long run have higher expected returns in exchange for the investor having to suffer through that higher volatility.

Some could say that by adding a small cap tilt, they're adding exposure to different kinds of risks. However, are small company risks truly different than large company risks - or the same, just greater in magnitude?

Note: expected returns are by no means garunteed. Risk involves risk of loosing money, even over long periods. Investors never should bear risk beyond their willingness, ability, and need to take risk.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Random Walker » Sun Oct 22, 2017 7:19 pm

TD2626 wrote
Is it possible that returns from factors are simply explained by excess risk? For example, some could argue that small cap stocks are more risky and therefore over the long run have higher expected returns in exchange for the investor having to suffer through that higher volatility.

Some could say that by adding a small cap tilt, they're adding exposure to different kinds of risks. However, are small company risks truly different than large company risks - or the same, just greater in magnitude?

Note: expected returns are by no means garunteed. Risk involves risk of loosing money, even over long periods. Investors never should bear risk beyond their willingness, ability, and need to take risk.
I think size and value are definitely risk stories, and value likely also has some behavioral too. Momentum I think is all behavioral. I don’t know what to think of profitability. The risk explanations seem pretty flimsy to me. I think small (and value?) stocks have both more of the same kind of risks as market beta (beta >1) and unique risks. The fact that SmB and HmL are defined as long-short portfolios eliminates market beta from the issue. And the lack of correlation between market, SmB, HmL further supports their uniqueness I believe.

With regard to not assuming more risk than one can handle, perhaps one take on a bit more risk than they otherwise might with a TSM portfolio if the risks were multiple, independent, weakly or uncorrelated.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by nisiprius » Sun Oct 22, 2017 8:44 pm

avalpert wrote:
Sun Oct 22, 2017 11:01 am
nisiprius wrote:
Sun Oct 22, 2017 10:47 am
Look, all you are buying in the supermarket is "food." Don't you think you should be diversifying into motor oil, fidget spinners, and romance novels?
Given the rest of your reasoning here isn't that last question disingenuous? I mean, I can explain why food is helpful in providing me nutrients and energy but I can't even pretend that motor oil, fidget spinners and romance novels can contribute to that in any way.
I didn't mean that seriously; I thought I was suggesting a loose analogy between "diversifying" away from securities and into new, faddish, "innovative" things. But, OK, let's strike that.
avalpert wrote:To take back to your last question - if I wanted to be equally disingenuous I would suggest you are only looking at calories when buying food, don't you think you should ensure a balance of vitamins and minerals as well? (and we can then let nutritional scientists have the same disagreements over which ones actually matter)...
I think that's actually worth pursuing. It's a legitimate criticism of what I said... up to a point.

If I can reframe it a bit, I think there's a valid analogy to be had if we look at counting calories in dieting, versus counting Weight Watcher's "Points Plus" points.

As presented by Weight Watchers, Points Plus values were calculated by means of proprietary calculator tools, using a secret formula, based on the number of grams of protein, carbohydrates, fat, and fiber in a food portion. It's easily determined that the formula is linear, and fairly easy to reverse engineer the calculation:

Points Plus = (16 x protein + 19 x carbohydrates + 45 x fat - 14 x fiber) / 175

It turns out that this is fairly close to 35 calories per point. For example, 35 calories of protein = 0.8 points; 35 calories of carbohydrates without any fiber = 0.95 points; 35 calories of fat = 1.0 points. Relative to calories, PointsPlus "underweights" protein slightly, and credits fiber. It's very hard to find foods in which the fiber level is so high that this makes a huge difference, though.

Although you can find various rational reasons for thinking Points Plus might be "better" than counting calories, it's hard to believe that counting Points Plus really gives provably better dieting results than counting calories. It is, however, a great marketing tool, because plan participants buy materials, guides, and tracking software that give Points Plus values rather than calories.

A further analogy is that Weight Watchers has moved on and discarded Points Plus in favor of a new, different system called SmartPoints... analogous to the three-factor model being displayed by newer factor, the importance of the size factor being deemphasized, etc.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by lack_ey » Sun Oct 22, 2017 10:10 pm

packer16 wrote:
Sun Oct 22, 2017 4:33 pm
The one point about the statement that factors explain 90% of security returns is true only in the past. If this was even true by significant margin over 50% in the future, the factors funds would be able to beat the pants off any other fund out there & this is not the case. Depending upon your time horizon these factors may only add risk with no return as the return they add is diversifiable.
This is not right at all. An equity factor model (CAPM) explains the returns of equity portfolios better than just market beta alone. Even the three-factor model still does a good job explaining most returns, far above 50%. Chances are, you pick any US equity mutual fund, and the performance is not drastically different from what would be expected from a weighted sum of market, size, and value factors with coefficients corresponding to what the fund owns. It should be no surprise generally that adding more variables can increase unadjusted R^2 in the model fit—it's just that size and value (or some other ones) can do a significantly better job of explaining returns than some nonsense factors that you might think up (e.g. return of stocks with the shortest names minus return of stocks with the longest names).

None of this gives you any direct insight about what the factor returns will be going forward. It could easily be that size gives you 0 return on average the next 30 years but still does a good job explaining portfolio returns. These are two different things. The reason why factor funds don't consistently win is because the factors don't consistently have positive returns. Never have, never will.



Everybody has to place bets based on beliefs about relative future factor returns. As pointed out earlier, differential factors are not really the same thing as the market factor (or term, or so on). You have to make educated guesses based on history and underlying theory for all of them, including market.

Differential factors are only really diversifying in the sense that they provide exposure to a durable source of return not explained by the other factors. If the return edge dissipates—and there are a lot of reasons given why they might not—then you're not really getting anything but higher risk from your more concentrated positions.

Factor-centric allocations are a way to get something different from the market via reweighting. A lot of things might be better than the market. A lot of things are also worse.

I would add that nobody's really any good at timing any of the factors, so I'd be skeptical of heavy reallocation based on tactical views, thinking one factor or another is expensive. Or at least if you do, don't expect to be particularly successful.

Non-differential alternatives such as other assets (gold, real estate, etc.), alternative types of credit risk, insurance, etc. are harder to evaluate but some may have more of a justification for potential return in a way that is not tied to the market or not tied to a stock's valuation (anything that's a stock, if the market is reasonably efficient and not stupid, has returns influenced by market pricing / discount rate and is thus weaker as a diversifier). These are outside an equity factor model, though some may still be correlated and economically related to existing factors you might be targeting.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by AlohaJoe » Sun Oct 22, 2017 10:42 pm

Random Walker wrote:
Sun Oct 22, 2017 9:58 am
It seems the factor talk has declined quite a bit recently. Market beta has had a great 8 year run. With P/E ratios very high and interest rates very low, I’m wondering if any Bogleheads are increasing their interest in diversifying across other potential sources of return: cross sectional Momentum, Time series Momentum, value, size, profitability, alternatives?
Yes. My recent US rebalancing has gone into multi-factor funds instead of vanilla TSM. But I haven't sold my existing TSM and converted it to multi-factor. That's partly, but not entirely, because my portfolio is primarily taxable and I don't see a point in paying lots of capital gains.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Random Walker » Sun Oct 22, 2017 11:09 pm

AlohaJoe,
I just sucked it up and paid a bunch of capital gains to make my allocation change. I certainly feel the pain of paying taxes, but they do need to be paid eventually. Moreover, I figured if my risk tolerance has truly changed I should make the change immediately. I think a lot depends where one is in the accumulation phase, early versus late. The lower the ratio of remaining human capital to accumulated financial capital, the more it probably makes sense to suck it up and pay the tax now.

Dave

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by HomerJ » Sun Oct 22, 2017 11:19 pm

Keep it simple is my motto.

I have zero interest in "factors". Stocks/bonds/cash meet my needs.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by AlohaJoe » Mon Oct 23, 2017 12:02 am

Random Walker wrote:
Sun Oct 22, 2017 11:09 pm
I just sucked it up and paid a bunch of capital gains to make my allocation change. I certainly feel the pain of paying taxes, but they do need to be paid eventually.
I agree they need to be paid eventually. However individual circumstances can affect when paying them is a better or worse idea; though I do think most people let the tax tail wag the dog. I already have substantial capital gains this year & next for other reasons, so I didn't really want to pay 23.8% just to switch out of TSM right now.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by packer16 » Mon Oct 23, 2017 6:43 am

lack_ey wrote:
Sun Oct 22, 2017 10:10 pm
packer16 wrote:
Sun Oct 22, 2017 4:33 pm
The one point about the statement that factors explain 90% of security returns is true only in the past. If this was even true by significant margin over 50% in the future, the factors funds would be able to beat the pants off any other fund out there & this is not the case. Depending upon your time horizon these factors may only add risk with no return as the return they add is diversifiable.
This is not right at all. An equity factor model (CAPM) explains the returns of equity portfolios better than just market beta alone. Even the three-factor model still does a good job explaining most returns, far above 50%. Chances are, you pick any US equity mutual fund, and the performance is not drastically different from what would be expected from a weighted sum of market, size, and value factors with coefficients corresponding to what the fund owns. It should be no surprise generally that adding more variables can increase unadjusted R^2 in the model fit—it's just that size and value (or some other ones) can do a significantly better job of explaining returns than some nonsense factors that you might think up (e.g. return of stocks with the shortest names minus return of stocks with the longest names).

None of this gives you any direct insight about what the factor returns will be going forward. It could easily be that size gives you 0 return on average the next 30 years but still does a good job explaining portfolio returns. These are two different things. The reason why factor funds don't consistently win is because the factors don't consistently have positive returns. Never have, never will.



Everybody has to place bets based on beliefs about relative future factor returns. As pointed out earlier, differential factors are not really the same thing as the market factor (or term, or so on). You have to make educated guesses based on history and underlying theory for all of them, including market.

Differential factors are only really diversifying in the sense that they provide exposure to a durable source of return not explained by the other factors. If the return edge dissipates—and there are a lot of reasons given why they might not—then you're not really getting anything but higher risk from your more concentrated positions.

Factor-centric allocations are a way to get something different from the market via reweighting. A lot of things might be better than the market. A lot of things are also worse.

I would add that nobody's really any good at timing any of the factors, so I'd be skeptical of heavy reallocation based on tactical views, thinking one factor or another is expensive. Or at least if you do, don't expect to be particularly successful.

Non-differential alternatives such as other assets (gold, real estate, etc.), alternative types of credit risk, insurance, etc. are harder to evaluate but some may have more of a justification for potential return in a way that is not tied to the market or not tied to a stock's valuation (anything that's a stock, if the market is reasonably efficient and not stupid, has returns influenced by market pricing / discount rate and is thus weaker as a diversifier). These are outside an equity factor model, though some may still be correlated and economically related to existing factors you might be targeting.
From your comments I think we are agreeing. Factors can explain the past but not the future. They may give us hints but to invest as though they can provide additional return or "diversification" by concentration, an oxymoron if I ever heard one, I believe is speculative. This idea also is contrary to the idea that the market provides the best estimate on average of security prices/weights in a market portfolio. Does the market mechanism work for active investing (stock selection) but not factor investing? This sounds more like hubris than anything else.

Do factors provide durable sources of return or are they past correlation? IMO some do provide durable returns & some do not. A durable source of return in based upon economics. Stocks will provide more return than bonds because they are subordinate to bonds in payment of firm cash flows. Other factors such as value & momentum are based upon non economic factors that may occasionly show up at specific time or places but the strategies to capture these are not based upon capturing them occasionly but constantly.

IMO the one way to concentrate in an intelligent way is to buy undervalued securities based upon conservative estimates of intrinsic value which requires a deeper understanding of businesses than factors provide.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by Random Walker » Mon Oct 23, 2017 8:55 am

Packer16 wrote
Factors can explain the past but not the future. They may give us hints but to invest as though they can provide additional return or "diversification" by concentration, an oxymoron if I ever heard one, I believe is speculative. This idea also is contrary to the idea that the market provides the best estimate on average of security prices/weights in a market portfolio.
I don’t think there is an oxymoron here. We are talking about the difference between the behavior of individual’s portfolios and the efficiency of the market, two different issues I believe.

Dave

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by lack_ey » Mon Oct 23, 2017 10:30 am

packer16 wrote:
Mon Oct 23, 2017 6:43 am
From your comments I think we are agreeing. Factors can explain the past but not the future. They may give us hints but to invest as though they can provide additional return or "diversification" by concentration, an oxymoron if I ever heard one, I believe is speculative. This idea also is contrary to the idea that the market provides the best estimate on average of security prices/weights in a market portfolio. Does the market mechanism work for active investing (stock selection) but not factor investing? This sounds more like hubris than anything else.

Do factors provide durable sources of return or are they past correlation? IMO some do provide durable returns & some do not. A durable source of return in based upon economics. Stocks will provide more return than bonds because they are subordinate to bonds in payment of firm cash flows. Other factors such as value & momentum are based upon non economic factors that may occasionly show up at specific time or places but the strategies to capture these are not based upon capturing them occasionly but constantly.

IMO the one way to concentrate in an intelligent way is to buy undervalued securities based upon conservative estimates of intrinsic value which requires a deeper understanding of businesses than factors provide.

Packer
No, you earlier stated that "The one point about the statement that factors explain 90% of security returns is true only in the past. If this was even true by significant margin over 50% in the future, the factors funds would be able to beat the pants off any other fund out there & this is not the case. "

That's not right. There's a big difference between (1) average factor return going forward and then (2) factor returns explaining portfolio returns going forward.

If we hold a portfolio of 200 small cap stocks for the next year with a good mix of industries and end up with factor loadings of 1 market, 1 size, 0 value, I still expect that the returns will be highly explained by the return of the market and the return of the size factor. When the market goes up, we go up. When the size factor goes up, we go up. We should be extremely highly correlated with the sum of the two, with high R^2. We're not going to have only 50% of returns explained by the factors.

What we don't know is what the factor returns will be next year. Maybe the size factor returns -5%. All of these are effectively random and highly unpredictable. It's not unusual for any given factor to have a negative return over a span of ten years. As for the long-term average going forward, if it's around zero for a factor, then there's usually not much use targeting it. It doesn't take factors not explaining returns anymore for factor funds to not work—it's sufficient for the mean factor return to be lower.

Our small cap portfolio might earn less than the market if the factor models completely fall apart and the size factor has a 2% return but the model has R^2 of 50% and we end up with alpha of -3%. But the more likely case is just that the size factor has a negative return over the period we're looking at.

Some factor investors believe the best estimate of forward factor returns is the historical factor return, that on average if in the US size returned 3.3% from 1926-2015 (arithmetic mean, lower geometric mean), we should expect 3.3% from the factor going forward. That's overly optimistic and naive for a number of reasons, I would say. It's probably lower than that. But how low? If you say 0% or even negative, this is saying there's no reward for taking more risk in small caps, that the market pricing is stupid in a sense. Also that the past return of 3.3% over many decades was some kind of fluke or now has structurally vanished. That seems rather abrupt. Usually the S&P 500 has slightly lower volatility than the total market, so if the small caps are not adding any return, then see ya... If it's actually 3.3% then this seems the market may be stupid in the other direction (depending on the additional risk). Estimating that is the real problem.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by asif408 » Mon Oct 23, 2017 11:06 am

I'm a factor doubter, personally. I think factors are like anything else in investing, they can be chased, and once enough people are chasing them performance over simple old boring market cap will fall below 0 until there is a mass exodus, and the cycle will renew itself again. Low vol and high dividend investing being the current areas I would avoid like the plague. You can see factor chasing will only increase because of the increasing offerings for factor investing, such as TDAmeritrade's addition of hundreds of factor ETFs to their commission free offerings recently. I literally had to sort painstakingly through all of the factor funds to find the few plain old boring market beta funds available. I can only imagine this is becoming more and more ubiquitous, and it's only a matter of time until Vanguard gets into the factor business.

For me, market beta is still tried and true. Market beta's run in the US has been impressive over the last 8 years, but its run in developed ex-US, emerging markets, energy, and precious metals has not been so much: http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D. And these laggards are all pretty much still below their spring of 2011 highs. So my investments are still market cap, but in areas that have been laggards or outright terrible since the bottom in March 2009. I pretty much eliminated all my US holdings last year, and don't have any plans to start adding to them any time soon. It was a good run for the US, but their are no good rational reasons IMO to believe it will continue to outperform. I also have no plans to jump on the factor bandwagon, US or International.

To me, all of the investors fixated on factor investing in the US are stepping over dollar bills trying to pick up pennies. The dollar bills they are stepping over are plain old boring markets cap funds in foreign stocks, energy, and PME, that they are too scared to pick up.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by rkhusky » Mon Oct 23, 2017 11:09 am

Random Walker wrote:
Sun Oct 22, 2017 9:58 am
By my guesstimates my 42%equities/38%bonds/20%alternatives portfolio has the same after tax expected return as a 85%equities/15% bonds TSM portfolio with a lower SD and a much lower potential maximum bear market loss. I believe my portfolio has and SD of about 12ish compared to about 15ish for the 85/15 TSM and a 50% decline in the equity markets would probably cause a 35-40% loss in the TSM portfolio versus 15-20% loss in my portfolio.
A 50% decline would involve substantial economic turmoil. Why would your alternatives be unaffected by that? And small and value stocks tend to drop more than TSM in a market crash.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by triceratop » Mon Oct 23, 2017 11:21 am

asif408 wrote:
Mon Oct 23, 2017 11:06 am
I'm a factor doubter, personally. I think factors are like anything else in investing, they can be chased, and once enough people are chasing them performance over simple old boring market cap will fall below 0 until there is a mass exodus, and the cycle will renew itself again. Low vol and high dividend investing being the current areas I would avoid like the plague. You can see factor chasing will only increase because of the increasing offerings for factor investing, such as TDAmeritrade's addition of hundreds of factor ETFs to their commission free offerings recently. I literally had to sort painstakingly through all of the factor funds to find the few plain old boring market beta funds available. I can only imagine this is becoming more and more ubiquitous, and it's only a matter of time until Vanguard gets into the factor business.

For me, market beta is still tried and true. Market beta's run in the US has been impressive over the last 8 years, but its run in developed ex-US, emerging markets, energy, and precious metals has not been so much: http://quotes.morningstar.com/chart/fun ... A%5B%5D%7D. And these laggards are all pretty much still below their spring of 2011 highs. So my investments are still market cap, but in areas that have been laggards or outright terrible since the bottom in March 2009. I pretty much eliminated all my US holdings last year, and don't have any plans to start adding to them any time soon. It was a good run for the US, but their are no good rational reasons IMO to believe it will continue to outperform. I also have no plans to jump on the factor bandwagon, US or International.

To me, all of the investors fixated on factor investing in the US are stepping over dollar bills trying to pick up pennies. The dollar bills they are stepping over are plain old boring markets cap funds in foreign stocks, energy, and PME, that they are too scared to pick up.
It's not possible to know how many factor investors, i.e. small + value tilters, there are here on BH.org but I suspect there are only a handful or fewer who are not exposed to developed markets or emerging markets. Many of us are allocated internationally at or near market weights, but tilt in each section of the portfolio. We don't spend too much time arguing about that aspect of things; diversification abroad just makes sense.

Speaking personally, certainly invest in market cap funds in foreign stocks, but also target factors, both domestically and abroad.
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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by stlutz » Mon Oct 23, 2017 11:24 am

If you are long value stocks and short growth stocks the performance of the overall market doesn't matter.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by KyleAAA » Mon Oct 23, 2017 11:49 am

TD2626 wrote:
Sun Oct 22, 2017 6:38 pm
Is it possible that returns from factors are simply explained by excess risk? For example, some could argue that small cap stocks are more risky and therefore over the long run have higher expected returns in exchange for the investor having to suffer through that higher volatility.
Yes. In fact, that's the preferred reality. If these factor sources are really compensation for risk, and if these risks are semi-independent of each other (which they do appear to be), that leads to a reliable source of additional portfolio efficiency. If they aren't explained by excess risk, we might have problems because investor psychology can change. That is why I tilt to small and value but not any of the more esoteric strategies with flimsier risk-based explanations.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by garlandwhizzer » Mon Oct 23, 2017 1:20 pm

Random Walker wrote in response to my post:
Also, you mention that at your age you wonder if there will be enough time for the factors to show their benefit. I would contend that the shorter the time horizon, possibly the more valuable factor diversification. Over short periods of time we don’t know what each of the factors, including the market factor, is going to do. Diversifying across factors may be even more useful over short periods. Curious to hear your thoughts.
I think a good argument can be made for multi-factor approaches which in theory produces less volatility than single factor (or perhaps even beta) and, likely, better returns. Multi-factor approaches work very well on backtesting for both returns and volatility when you set all trading and weighing parameters optimally in the rear view mirror. You simply choose what has worked in the past. Will those same parameters work equally well in the future after costs for investors? I think the answer to that question is less clear.

The multi-factor strategy is complex, a lot of moving parts with a long and multi-branched decision tree in choosing which factors to use, the relative weights between the chosen factors, and in setting the exact parameters for when to pull the trigger on trades for each factor. There is also an inherent conflict between MOM and VAL so how to set that balance is an ever present challenge. Multi-factor has a lot of potential but likely requires a very high level of skill in execution, not trading so much that all alpha is consumed, but trading enough to efficiently harvest factor returns, and finally not allowing VAL and MOM to destroy each other. It's a lot easier done in retrospect than going forward.

Increased costs are a problem with DFA multi-factor funds which require paid advisor for access. The AQR multi-factor funds have relatively high expense ratios and their QCELX multi-factor fund which operates in the LC space has actually slightly underperformed Vanguard's S&P 500 etf, VOO, since its inception 4 years ago. If I were to invest in a multi-factor fund, I would choose Goldman Sachs GSLC which is low in cost (0.09%) and utilizes a VAL, MOM, QUAL/PROFITABILITY approach. GSLC and has slightly outperformed VOO over its lifetime of only 2 years. Neither multi-factor fund has departed substantially from the returns of VOO over their short lifetimes although it is too early to draw firm conclusions.

I think it is reasonable to say that although very smart and knowledgeable guys are working on multi-factor approaches, at this point the jury is still out as to whether the increased costs and complexity will improve investor results. The US LC space is the most heavily scrutinized by professionals of all equity segments in the world. I am personally skeptical that any approach can be counted on to consistently outperform ultra-low cost beta in that space. I also suspect that in the SC space, the increased trading costs and frictions generated by multi-factor approaches are likely to eat up all the alpha produced.

I do believe multi-factor is a rational choice for those who strongly believe in factor investing. I'm too much of a skeptic to believe strongly in any theory. If you are interested I suggest you take a look at GSLC whose low cost structure is appealing to the only theory I know of that is always true, the Cost Matters Hypothesis.

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Re: After Market Beta’s Long Run Do you Consider Diversifying Into Other Factors?

Post by lack_ey » Mon Oct 23, 2017 2:04 pm

garlandwhizzer wrote:
Mon Oct 23, 2017 1:20 pm
Increased costs are a problem with DFA multi-factor funds which require paid advisor for access. The AQR multi-factor funds have relatively high expense ratios and their QCELX multi-factor fund which operates in the LC space has actually slightly underperformed Vanguard's S&P 500 etf, VOO, since its inception 4 years ago. If I were to invest in a multi-factor fund, I would choose Goldman Sachs GSLC which is low in cost (0.09%) and utilizes a VAL, MOM, QUAL/PROFITABILITY approach. GSLC and has slightly outperformed VOO over its lifetime of only 2 years. Neither multi-factor fund has departed substantially from the returns of VOO over their short lifetimes although it is too early to draw firm conclusions.
Just keep in mind the different possible approaches to multifactor funds. You can run N single-factor portfolios or do a single sort over a multifactor metric. The former approach may end up picking a mid-high momentum stock with very low value and very low profitability that may score poorly across multiple factors you are targeting, just because it falls into the momentum side for inclusion in one of the sub-portfolio allocations. The latter approach may end up picking a stock that's not really high anything, but slightly momentum, value, etc.

The Goldman funds like GSLC uses the former approach (which recently has happened to do a bit better), while AQR and some others do the latter. I think the latter way makes more sense generally, but at least with the former you may end up with something more marketlike and get lower tracking error to a vanilla benchmark. You usually should end up with higher overall factor loads doing it the latter way. Obviously the question is then whether it makes more sense to pay extra for the type of exposure you want. In any case, all the AQR long-only funds look expensive to me; there are others doing similar things there.

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