Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

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Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by matjen » Fri Dec 15, 2017 8:36 am

For all the Factor Fans on the Board and all you haters with your time period selected arguments. ;-)
Momentum and Small Cap Value seem to be pretty good strategies (but hey, cap weight is perfectly fine as well).
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk. It is important, therefore, to understand these exposures when developing an investment strategy or when evaluating a fund manager’s performance. Furthermore, a factor that is ranked high in performance in a particular year may remain high, may end up in the middle, or may slip to low in the following year. Exhibit 1 lists, in addition to 2016, each year’s factor returns since the financial crisis, ranked from highest to lowest. Since the global financial crisis, the ranking of factor returns has not been stable, and earlier years (not shown here) are similar. Because of the inherent unpredictability of risk premiums, perceptive investors diversify their portfolios across risk exposures.
Elroy Dimson, Paul Marsh and Mike Staunton
Factor-Based Investing: The Long-Term Evidence
The Journal of Portfolio Management Special QES Issue 2017
http://jpm.iijournals.com/content/43/5/15

PDF is here: http://jpm.iijournals.com/content/iijpo ... 5.full.pdf
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by livesoft » Fri Dec 15, 2017 8:40 am

But what I want to know is when one should switch horses among the factors? For instance, US small-cap value trailed in 2017, but did great in 2016. And foreign small caps trailed in 2016, but did great in 2017. Which factor is going to be the best performing factor over the next 12 months? I want to overweight my Roth IRA with that factor.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by matjen » Fri Dec 15, 2017 8:43 am

livesoft wrote:
Fri Dec 15, 2017 8:40 am
But what I want to know is when one should switch horses among the factors? For instance, US small-cap value trailed in 2017, but did great in 2016. And foreign small caps trailed in 2016, but did great in 2017. Which factor is going to be the best performing factor over the next 12 months? I want to overweight my Roth IRA with that factor.
Don't we all! :wink: One could say the same thing about sectors or individual stocks when talking about cap weight strategy couldn't they?
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 9:07 am

In all, researchers have identified at least 316 factors, of which Harvey, Liu, and Zhu [2016] point out that nearly all are unlikely to be robust in independent testing. Novy-Marx and Velikov [2015] and Green, Hand, and Zhang [2017] express complementary doubts about the prospective profits from exploiting factors that appear promising on an in-sample basis. The problem of apparently significant in-sample results being nonrobust in out-of-sample (OOS) tests has been discussed for more than a quarter of a century; see, for example, Dimson and Marsh [1990] and Markowitz and Xu [1994]. But there is no substitute for genuine OOS testing. Harvey [2017] notes the impracticality of waiting for additional data in order to test a model’s OOS reliability—not to mention the understandable impatience of practitioners.
A frustrating feature of factor risk premiums is that they may simply be transient anomalies in stock market behavior. When that is the case, no sooner have they been identified than they cease to work. Meanwhile, with the benefit of over a century of financial market history, we can try to discern whether there are enduring regularities in stock price behavior, or whether there are patterns that reflect chance events or circumstances that are episodic and cannot be expected to recur. In the sections that follow, we discuss what we can learn from up to 117 years of stock market history, and draw some conclusions on the permanence or transience of factor premiums over the course of such history.
It's still not clear to me why we can trust predictions of future factor performance that is based on data from before the factors were widely known and invested in. What would be the demarcation date for the phase change in factor investing? First Fama-French publication? Introduction of DFA factor based funds? Introduction of Vanguard factor-based funds?

Beginning of concluding remarks:
We have discussed five aspects of factor-based investing that are of great importance to investors. They matter because investment professionals cite strong evidence that they contribute to long-term returns. There is a size effect, in that smaller companies behave differently from large ones. There is a value effect, whereby value stocks perform differently from growth stocks. There is an income effect, with high yielders performing differently from low- and zero yielders, although this may also be regarded as a subset of the value effect. There is a momentum effect, whereby stocks with relative strength generate different returns from stocks with relative weakness. In addition, there is a low-volatility effect that is apparent in some markets. These effects cannot be ignored.

By an “effect,” we mean a tendency for stocks with certain attributes to co-move with one another. For example, value stocks move together, and in a different direction to growth stocks. The reason these effects cannot be ignored is that they are likely to have an impact on portfolio performance. In addition to co-movement, there may also be a premium in expected returns for exposure to these factors. However, the evidence on premiums is not conclusive.
My conclusion: There exists clusters of stocks, such that stocks within a cluster behave similarly and stocks in different clusters behave differently. The evidence for future out-performance of any one cluster is not conclusive. Therefore, buy all clusters. And the cheapest and most efficient way to do that is with total market funds.
Last edited by rkhusky on Fri Dec 15, 2017 9:21 am, edited 2 times in total.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by Random Walker » Fri Dec 15, 2017 9:19 am

The chart ranks the factors in order of relative performance. I think that isn’t so important. What is important is how often each factor is positive or negative and of course the fact we can’t predict what any given factor will do in any given time period. Diversifying across the factors is certainly the way to go!

Dave

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nisiprius » Fri Dec 15, 2017 9:23 am

I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?

Second, what does it mean to say that a total market investor is "knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk?" If I go to PortfolioVisualizer and type "VTSMX" into the "Mutual Fund and ETF Factor Regressions" page, this is what I see:

Image

Personally, I would describe this by saying that, no, I am not exposed to SMB (size), HML (value), or MOM (momentum). I am not "knowingly or unknowingly exposed to factors such as size, value... momentum." How would you describe it?

Honestly, you wouldn't say "I'm a factor investor whether I know it or not, because I invest in the market factor?"

"Well, what do you know about that! These forty years now I've been speaking in prose without knowing it!"
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 9:24 am

I think a comment about factor investing is that cap weighting is not diversified across factors as the loading is zero on all the factors except market, unless I don't understand. I think they meant not to make bets on size rather than value rather than x rather than y . . . at any particular time.

I do agree that cap weighting is fine, but that is not an argument from advocates of factor investing other than Fama or French him/their selves.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by matjen » Fri Dec 15, 2017 9:25 am

Nisi I agree. I was confused by that sentence as well. Perhaps they are referring to anyone who isn't pure market cap.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 9:28 am

nisiprius wrote:
Fri Dec 15, 2017 9:23 am
I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?

Second, what does it mean to say that a total market investor is "knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk?" If I go to PortfolioVisualizer and type "VTSMX" into the "Mutual Fund and ETF Factor Regressions" page, this is what I see:



Personally, I would describe this by saying that, no, I am not exposed to SMB (size), HML (value), or MOM (momentum). I am not "knowingly or unknowingly exposed to factors such as size, value... momentum." How would you describe it? Honestly, you wouldn't say "I'm a factor investor whether I know it or not," would you?
Apparently someone is using risk to mean the market "factor," although I guess sometimes "market" is not called a factor so that one can distinguish a portfolio loaded on some actual factors from the market portfolio. What the statement about "unknowingly" is supposed to mean, I have no idea. Maybe they are talking about people who buy actively managed funds without appreciating that what they are buying is tilted relative to the "market."

It is some of the usual mangling of language when someone could say clearly what they mean, though it might take more words.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by Lauretta » Fri Dec 15, 2017 9:40 am

livesoft wrote:
Fri Dec 15, 2017 8:40 am
But what I want to know is when one should switch horses among the factors? For instance, US small-cap value trailed in 2017, but did great in 2016. And foreign small caps trailed in 2016, but did great in 2017. Which factor is going to be the best performing factor over the next 12 months? I want to overweight my Roth IRA with that factor.
good question. I think that some people like O'Shaughnessy, (if I understand him correctly) would say that you should stick with each factor strategy for many years (there will be times, unpossible to know in advance, when it will underperform but you should stick with it) overall in the long terms it will beat the market.

On the other hand some people I have corresponded with think it's actually possible to predict the periods in which different strategies will work. For example an active manager said that for value price flexibility is best and gave me an explanation of when small caps work best, in terms I don't really understand :confused :confused but it's just to say that some people actually think they can know when each factor is going to work.

I am personally overweight in European small caps (for tax purposes) and sometimes worry that they will stop outperforming and that a serious correction is coming seeing their higher valuations relative to large cap. Who knows...
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by livesoft » Fri Dec 15, 2017 9:46 am

Lauretta wrote:
Fri Dec 15, 2017 9:40 am
good question. I think that some people like O'Shaughnessy, (if I understand him correctly) would say that you should stick with each factor strategy for many years (there will be times, unpossible to know in advance, when it will underperform but you should stick with it) overall in the long terms it will beat the market.
I am happy to stick with all factors all the time, but I want to know which one to put in my Roth IRA for 2018 and which ones to put in my tax-deferred accounts. :twisted:
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by Random Walker » Fri Dec 15, 2017 9:54 am

Rkhusky,
Good points. With regard to out of sample evidence, I think it can be obtained in a few different ways: different time periods, different geographic markets, different asset classes.
I think it’s also important to look at sub periods within a time period. There is value in having the longest time period possible, and there is value in having the most similar time period to the present as well. Longer is better, but also important to look at post publication and post readily investable sub periods.
Lastly, because data can always be questioned and because we invest looking forward, I think a logical intuitive risk or behavioral based belief in the factor is necessary to stay committed to it. Past data is not enough.

Dave

P.S. the fact that factors are pervasive across different asset classes (equities, bonds, currencies, commodities) I find quite powerful

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by lack_ey » Fri Dec 15, 2017 10:06 am

nisiprius wrote:
Fri Dec 15, 2017 9:23 am
I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?
Checking the paper very briefly, it seems like a reference to risk in the context of volatility, analyzing high risk vs. low risk stocks, low vol and low beta strategies, and similar constructions (start on page 30). It's not about overall stock market risk.

If you had a non-market allocation, you might have nontrivial exposure there in terms of being tilted to low volatility or the opposite, just as one of the others.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by UpsetRaptor » Fri Dec 15, 2017 10:35 am

livesoft wrote:
Fri Dec 15, 2017 8:40 am
But what I want to know is when one should switch horses among the factors? For instance, US small-cap value trailed in 2017, but did great in 2016. And foreign small caps trailed in 2016, but did great in 2017. Which factor is going to be the best performing factor over the next 12 months? I want to overweight my Roth IRA with that factor.
I see what you did there. :D

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nisiprius » Fri Dec 15, 2017 11:21 am

lack_ey wrote:
Fri Dec 15, 2017 10:06 am
nisiprius wrote:
Fri Dec 15, 2017 9:23 am
I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?
Checking the paper very briefly, it seems like a reference to risk in the context of volatility, analyzing high risk vs. low risk stocks, low vol and low beta strategies, and similar constructions (start on page 30). It's not about overall stock market risk.

If you had a non-market allocation, you might have nontrivial exposure there in terms of being tilted to low volatility or the opposite, just as one of the others.
But I don't have a non-market allocation. Yes or no, in your opinion, used the way you use the terminology, think it's generally used, and think it should be used...

...do you feel that I, holding only VTSMX (and Total International, VGTSX) am "knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk?"

If you agree with me that, no, I do not... then do you feel the number of total market investors like me is so negligible that it is fair to say that "almost all" investors are exposed to these non-market factors?

Finally, then, do we both think that these authors have, for some reason, chosen to call the factor that is usually called "low volatility" by the name "risk," thus adding another meaning to an already-fraught term and, for maximum confusion, reversing its direction at the same time? Why on earth would they do that? Is this a U.S.-versus-British thing?
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by lack_ey » Fri Dec 15, 2017 11:35 am

nisiprius wrote:
Fri Dec 15, 2017 11:21 am
But I don't have a non-market allocation. Yes or no, in your opinion, used the way you use the terminology, think it's generally used, and think it should be used...

...do you feel that I, holding only VTSMX (and Total International, VGTSX) am "knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk?"

If you agree with me on that, then do you feel the number of total market investors is so negligible that it is fair to say that "almost all" investors are exposed to these factors?
I would say that you are not exposed to those factors, at least not beyond some trivial levels.

I think it's fair to say that pure total market investors are a small enough group such that almost all investors actually are exposed (if only to a small degree), unlike you. There are a lot of financial advisors putting clients in some active funds in addition to some passive funds, many who tilt to one thing or another, yet others who own S&P 500 funds rather than the whole market because that's what's available in their retirement plans, etc. Even passive investing aficionados like Bogle himself have some active funds. I forget the exact figure, but it's what, something like 20-30% of the US stock market is in passive strategies? A whole bunch of that is not total market funds, and a whole bunch of the people holding total market funds may have other equity investments.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 11:42 am

lack_ey wrote:
Fri Dec 15, 2017 11:35 am
nisiprius wrote:
Fri Dec 15, 2017 11:21 am
But I don't have a non-market allocation. Yes or no, in your opinion, used the way you use the terminology, think it's generally used, and think it should be used...

...do you feel that I, holding only VTSMX (and Total International, VGTSX) am "knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk?"

If you agree with me on that, then do you feel the number of total market investors is so negligible that it is fair to say that "almost all" investors are exposed to these factors?
I would say that you are not exposed to those factors, at least not beyond some trivial levels.

I think it's fair to say that pure total market investors are a small enough group such that almost all investors actually are exposed (if only to a small degree), unlike you. There are a lot of financial advisors putting clients in some active funds in addition to some passive funds, many who tilt to one thing or another, yet others who own S&P 500 funds rather than the whole market because that's what's available in their retirement plans, etc. Even passive investing aficionados like Bogle himself have some active funds. I forget the exact figure, but it's what, something like 20-30% of the US stock market is in passive strategies? A whole bunch of that is not total market funds, and a whole bunch of the people holding total market funds may have other equity investments.
Yes, that is a good description of what I also meant in my post. I suppose very few people would actually just buy a total market index fund and leave it alone. The theory is that such a fund has zero loading on any factors, other than "market" if that is a factor. If in theory there is a difference between an actual total market index fund and a theoretically pure portfolio, then there would be a statement there, but I bet the paper has in mind what lackey is explaining.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by staythecourse » Fri Dec 15, 2017 11:52 am

nisiprius wrote:
Fri Dec 15, 2017 9:23 am
Honestly, you wouldn't say "I'm a factor investor whether I know it or not, because I invest in the market factor?"
Actually yes you are a factor investor. That is the whole point of that comment. Granted he should have mentioned BETA, but didn't specifically mention but saying "such as" means examples and not limited to just those mentioned.

You as well as I know the original FF THREE factor model includes BETA along with size and value.

This was an argument on another thread by some random FA article. YES everyone invests in factors. If you believe in only BETA great. If you believe in 3 or 5 or whatever great. I invest in 3 factors (beta, value, and size) but don't deny there is momentum and liquidity just because I don't do it.

Good luck.

p.s. One of the BIG reasons folks believe in these other factors is because they are INDEPENDENT to beta (the first factor). The correlation of beta to the other factors is really low (?noncorrelation).
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by JoMoney » Fri Dec 15, 2017 12:28 pm

I know of and acknowledge the idea of "Risk Factors" as a prominent explanation for the returns in stocks.
But I still reject the idea of BETA and the EMH in general as being a reason I invest in a low-cost broad market index fund, as a sufficient model explaining the returns in stocks, and as a investment strategy to try and boost returns by increasing risk within that paradigm/premise.
So, No.. BETA plays no role my investment strategy.
Are Markets Efficient? … And Does It Matter?
The validity of the EMH makes for an intellectually stimulating debate. But I would argue that
for the average investor saving for retirement, or their children’s education, or to pass on an inheritance to
their heirs, the EMH debate is not particularly relevant. There is, however, a simple mathematical
tautology that all investors should understand. John Bogle (2005) calls this essential pearl of wisdom the
Cost Matters Hypothesis (CMH). The CMH simply states: Gross returns in the financial markets minus
the costs of financial intermediation equals the net returns actually delivered to investors. As Jack put it
in his article “The Relentless Rules of Humble Arithmetic,” “No matter how efficient or inefficient
markets may be, the returns earned by investors as a group must fall short of the market returns by
precisely the amount of the aggregate costs they incur. It is the central fact of investing.”
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by staythecourse » Fri Dec 15, 2017 12:41 pm

JoMoney wrote:
Fri Dec 15, 2017 12:28 pm
I know of and acknowledge the idea of "Risk Factors" as a prominent explanation for the returns in stocks.
But I still reject the idea of BETA and the EMH in general as being a reason I invest in a low-cost broad market index fund, as a sufficient model explaining the returns in stocks, and as a investment strategy to try and boost returns by increasing risk within that paradigm/premise.
So, No.. BETA plays no role my investment strategy.
Are Markets Efficient? … And Does It Matter?
The validity of the EMH makes for an intellectually stimulating debate. But I would argue that
for the average investor saving for retirement, or their children’s education, or to pass on an inheritance to
their heirs, the EMH debate is not particularly relevant. There is, however, a simple mathematical
tautology that all investors should understand. John Bogle (2005) calls this essential pearl of wisdom the
Cost Matters Hypothesis (CMH). The CMH simply states: Gross returns in the financial markets minus
the costs of financial intermediation equals the net returns actually delivered to investors. As Jack put it
in his article “The Relentless Rules of Humble Arithmetic,” “No matter how efficient or inefficient
markets may be, the returns earned by investors as a group must fall short of the market returns by
precisely the amount of the aggregate costs they incur. It is the central fact of investing.”
I totally disagree with Mr. Bogle that EMH does not matter. IF one did not believe in EMH or close enough then it lends to the obvious question to be posed of, "Cost may matter, but will paying more to this person be worth it if the market is not efficient enough and they can generate more alpha then I am losing in costs instead of just putting it in index funds with no alpha despite being the lowest cost".

Good luck.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by JoMoney » Fri Dec 15, 2017 1:09 pm

staythecourse wrote:
Fri Dec 15, 2017 12:41 pm
... IF one did not believe in EMH or close enough then it lends to the obvious question to be posed of, "Cost may matter, but will paying more to this person be worth it if the market is not efficient enough and they can generate more alpha then I am losing in costs instead of just putting it in index funds with no alpha despite being the lowest cost".

Good luck.
Without an "efficient market" the problem becomes one of skill and information, if you have the skill and information to select better stocks or a better stock picker then that's the way to go. I'm partial to the evidence that a very small segment of investors are able to do this, I have no reasons to think that includes me nor is it a game I want to engage in.
I'd rather avoid the risk that I'm likely to pick one of larger segment of under-performers, and pay more for it.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 1:28 pm

staythecourse wrote:
Fri Dec 15, 2017 11:52 am
nisiprius wrote:
Fri Dec 15, 2017 9:23 am
Honestly, you wouldn't say "I'm a factor investor whether I know it or not, because I invest in the market factor?"
Actually yes you are a factor investor. That is the whole point of that comment. Granted he should have mentioned BETA, but didn't specifically mention but saying "such as" means examples and not limited to just those mentioned.

You as well as I know the original FF THREE factor model includes BETA along with size and value.

This was an argument on another thread by some random FA article. YES everyone invests in factors. If you believe in only BETA great. If you believe in 3 or 5 or whatever great. I invest in 3 factors (beta, value, and size) but don't deny there is momentum and liquidity just because I don't do it.

Good luck.

p.s. One of the BIG reasons folks believe in these other factors is because they are INDEPENDENT to beta (the first factor). The correlation of beta to the other factors is really low (?noncorrelation).
IMO, the confusion is a result of sloppy terminology. As discussed in the paper, the factors consist of long and short positions (e.g. Small minus Big). However, for cost and complexity reasons many people ignore the short positions and simply tilt to the long positions. They then redefine the term 'factor' and call long positions in Small or Value, factor investing. So, yes, total market investors have small stocks, value stocks, high momentum stocks, low volatility stocks, etc, which are called factors, but they do not have Small minus Big, High minus Low etc which are also called factors. Perhaps small, value etc should be called pseudo-factors.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by triceratop » Fri Dec 15, 2017 2:07 pm

rkhusky wrote:
Fri Dec 15, 2017 1:28 pm
staythecourse wrote:
Fri Dec 15, 2017 11:52 am
nisiprius wrote:
Fri Dec 15, 2017 9:23 am
Honestly, you wouldn't say "I'm a factor investor whether I know it or not, because I invest in the market factor?"
Actually yes you are a factor investor. That is the whole point of that comment. Granted he should have mentioned BETA, but didn't specifically mention but saying "such as" means examples and not limited to just those mentioned.

You as well as I know the original FF THREE factor model includes BETA along with size and value.

This was an argument on another thread by some random FA article. YES everyone invests in factors. If you believe in only BETA great. If you believe in 3 or 5 or whatever great. I invest in 3 factors (beta, value, and size) but don't deny there is momentum and liquidity just because I don't do it.

Good luck.

p.s. One of the BIG reasons folks believe in these other factors is because they are INDEPENDENT to beta (the first factor). The correlation of beta to the other factors is really low (?noncorrelation).
IMO, the confusion is a result of sloppy terminology. As discussed in the paper, the factors consist of long and short positions (e.g. Small minus Big). However, for cost and complexity reasons many people ignore the short positions and simply tilt to the long positions. They then redefine the term 'factor' and call long positions in Small or Value, factor investing. So, yes, total market investors have small stocks, value stocks, high momentum stocks, low volatility stocks, etc, which are called factors, but they do not have Small minus Big, High minus Low etc which are also called factors. Perhaps small, value etc should be called pseudo-factors.
The only thing confusing terminology is your post. Factor investors are always talking about factor loads, I.e. the recognition that many long-only primarily-index funds do not achieve full exposure to these factors but only partial exposure. It's not a confusion of terminology, it's a day to day fact that we deal with this. For example some indexes provide higher exposures, so some factor investors prefer the S&P600 Value to the CRSP Small Value, and they choose their index funds based on the factor exposures.

Yes, long only positions can be factor investing. As an example, when you hold 50/50 US Stocks/Treasuries you do not have pure exposure to beta or term either. And yet you are a factor investor.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by Random Walker » Fri Dec 15, 2017 2:43 pm

Rkhusky,
Don’t think term “pseudo factors” is necessary. As you say, the factors are defined with long-short portfolios. About half the factor premium comes from the long position and half from the short position. People who use long only funds to gain factor exposure are simply exposing themselves to about half the premium.

Dave

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 2:48 pm

triceratop wrote:
Fri Dec 15, 2017 2:07 pm
The only thing confusing terminology is your post. Factor investors are always talking about factor loads, I.e. the recognition that many long-only primarily-index funds do not achieve full exposure to these factors but only partial exposure. It's not a confusion of terminology, it's a day to day fact that we deal with this. For example some indexes provide higher exposures, so some factor investors prefer the S&P600 Value to the CRSP Small Value, and they choose their index funds based on the factor exposures.

Yes, long only positions can be factor investing. As an example, when you hold 50/50 US Stocks/Treasuries you do not have pure exposure to beta or term either. And yet you are a factor investor.
Please explain this quote from the article in regards to total market investors:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk
As noted above, Total Stock Market has no exposure to size, value, yield, momentum, volatility, factors, that is the long/short factors.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by triceratop » Fri Dec 15, 2017 3:04 pm

rkhusky wrote:
Fri Dec 15, 2017 2:48 pm
triceratop wrote:
Fri Dec 15, 2017 2:07 pm
The only thing confusing terminology is your post. Factor investors are always talking about factor loads, I.e. the recognition that many long-only primarily-index funds do not achieve full exposure to these factors but only partial exposure. It's not a confusion of terminology, it's a day to day fact that we deal with this. For example some indexes provide higher exposures, so some factor investors prefer the S&P600 Value to the CRSP Small Value, and they choose their index funds based on the factor exposures.

Yes, long only positions can be factor investing. As an example, when you hold 50/50 US Stocks/Treasuries you do not have pure exposure to beta or term either. And yet you are a factor investor.
Please explain this quote from the article in regards to total market investors:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk
As noted above, Total Stock Market has no exposure to size, value, yield, momentum, volatility, factors, that is the long/short factors.
Those two quotes are completely unrelated?!

Anyway it's already been explained that most investors are not holding a total market fund.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by TJSI » Fri Dec 15, 2017 3:14 pm

Aren't factors just correlations with lipstick applied?

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by bertilak » Fri Dec 15, 2017 3:28 pm

nisiprius wrote:
Fri Dec 15, 2017 9:23 am
I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?
I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet. I generally posed this as a question in response to some Larry Swedroe comment. Eventually he corrected me to say that being "exposed" to a factor means holding it in some other proportion than the cap-weighted TSM. I accept his correction but have not yet seen how that helps me chose what factors to be exposed to, leaving me back at TSM.

Accepting that correction may eventually lead me to an understanding were I start tilting to some set of factors, but I am not there yet and so far am not leaning in that direction. I just accept I don't know but I am not encouraged that it is worth pursuing.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by lack_ey » Fri Dec 15, 2017 3:56 pm

TJSI wrote:
Fri Dec 15, 2017 3:14 pm
Aren't factors just correlations with lipstick applied?

TJSi
Correlations of what? I'm not sure how to interpret this, in the sense that there are logically maybe some words and concepts missing, like somebody stating that balls are just fitness.

It's generally possible to compute correlations between all kinds of different things, including factors.

A factor is a characteristic shared by a group of securities that help define and explain their risk and return patterns relative to other securities (to a certain extent). Usually a factor return is defined as the relative return between two different groups, one sharing the characteristic and the other having the opposite property.

You can use factors to analyze commonalities and differences between allocations, even those that may have significantly different holdings. This can be useful to understand what has happened. For example, if an actively managed fund with an ER of 1% beats the S&P 500 by 1% a year for a decade, maybe this sounds good, until you look at a factor attribution that shows that it was significantly tilted to growth stocks and high quality names in a decade where growth stocks did well (value had a negative return, with value factor -3% a year) and quality stocks also did well.

Some take an additional leap of looking for factors that historically over some data have had positive returns on average and assume that this means there's some decent chance there will be some positive returns on average going forward (if not as high as before). This is I think where you might want to lodge a complaint. Not with the framework as a whole, unless you think there are no patterns and commonalities at all, and these are all mirages, that there's not any particular reason why if most small caps do poorly, maybe others are more likely to do poorly simultaneously, and so on, that it's all noise.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by patrick013 » Fri Dec 15, 2017 3:57 pm

matjen wrote:
Fri Dec 15, 2017 8:36 am
For all the Factor Fans on the Board and all you haters with your time period selected arguments. ;-)
Nothing better than Long Term Evidence. When markets are high all the
indexes are high so when to do what is all the time isn't it ?

Thanks for the pdf.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 4:05 pm

triceratop wrote:
Fri Dec 15, 2017 3:04 pm
rkhusky wrote:
Fri Dec 15, 2017 2:48 pm
triceratop wrote:
Fri Dec 15, 2017 2:07 pm
The only thing confusing terminology is your post. Factor investors are always talking about factor loads, I.e. the recognition that many long-only primarily-index funds do not achieve full exposure to these factors but only partial exposure. It's not a confusion of terminology, it's a day to day fact that we deal with this. For example some indexes provide higher exposures, so some factor investors prefer the S&P600 Value to the CRSP Small Value, and they choose their index funds based on the factor exposures.

Yes, long only positions can be factor investing. As an example, when you hold 50/50 US Stocks/Treasuries you do not have pure exposure to beta or term either. And yet you are a factor investor.
Please explain this quote from the article in regards to total market investors:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk
As noted above, Total Stock Market has no exposure to size, value, yield, momentum, volatility, factors, that is the long/short factors.
Those two quotes are completely unrelated?!

Anyway it's already been explained that most investors are not holding a total market fund.
I wonder what percentage of investors simply use target date funds, considering that is becoming the default in many companies. I also imagine that many others simply use an S&P 500 fund for their stock allocation. I suspect that most investors have only incidental factor exposure.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by TJSI » Fri Dec 15, 2017 4:44 pm

lack_ey

Thank you for your response to my cryptic comment. This was an attempt at early morning humor--perhaps I needed more sleep.

But when all is said and done are not factors just correlations about whch a very elaborate lanuage has developed? So no one says such and such a factor is correlated with a return rather the more gentle expression "explains" is used. So A plus B plus C factors explan 95% of returns which really means there is a 95% correlation of the factors with return.

Now I happen to accept that these facors/ correlations do exist and are useful. The evidence of small cap-value is very solid. But it should always be warned that the factors can disapear for extended periods.

TJSI

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 4:47 pm

TJSI wrote:
Fri Dec 15, 2017 4:44 pm
lack_ey

Thank you for your response to my cryptic comment. This was an attempt at early morning humor--perhaps I needed more sleep.

But when all is said and done are not factors just correlations about whch a very elaborate lanuage has developed? So no one says such and such a factor is correlated with a return rather the more gentle expression "explains" is used. So A plus B plus C factors explan 95% of returns which really means there is a 95% correlation of the factors with return.

Now I happen to accept that these facors/ correlations do exist and are useful. The evidence of small cap-value is very solid. But it should always be warned that the factors can disapear for extended periods.

TJSI
More specifically factors are the variables that are significant in a regression model. In that sense it is correlation. Another part of that is sorting out models for the greatest amount of explanation in the statistical sense while choosing factors that are the least correlated with each other.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nisiprius » Fri Dec 15, 2017 5:50 pm

One of the things that I don't quite understand... I had originally thought that factors were extracted by a mathematical technique called factor analysis. I've never been deeply enough into it to know offhand just how that works. It's similar, but not identical to principal components analysis, which I have done (i.e. written computer programs to do it). Principal components analysis takes a swarm of measurements of many different things. In the case of stocks it could be, say, the 600 monthly total return numbers of each individual stock for the last fifty years, treats them as points in multidimensional space, and asks "are these really scattered across 600 different dimensions?" Often they aren't, and by rotating the axes around you can arrange them so that one axis goes through the longest spread of the swarm, then you sweep the second axis around, staying at 90% to the first axis, until it transects the widest spread it can, and so forth. With luck, it may turn out that the whole swarm is really only one-dimensional, or two-dimensional, or three-dimensional, with a fairly small amount of noisy spread in the other directions. The first few dimensions capture almost all of the total variance of the swarm.

Now that sounds a lot like the way the factor mavens talk, but there's an important difference. The procedure for principal components analysis keeps the axes at 90° to each other. That is, the axes are constructed in such a way that there is always zero correlation between the projection of each point on the axes.

Apparently that's not what the financial factor investigators do. Apparently they simply define the factors in some plausible ad-hoc way, and then observe what the correlations are; and they aren't zero. They aren't independent. That is to say, if I have my head screwed on right, the momentum factor itself has a loading on the value factor, and so forth.

I don't know why they do it that way. That's just a statement. I'm not saying they're wrong, I'm saying I don't understand why they do it that way.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by garlandwhizzer » Fri Dec 15, 2017 5:55 pm

Very good article, thanks for posting, matjen. It is IMO an objective analysis, not a sales pitch, and it provides good background information that might benefit both factor and cap-weighted index investors. If you're pressed for time, the concluding remarks starting on page 33 in the PDF version give a good Cliff-Notes-type summary.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 6:02 pm

nisiprius wrote:
Fri Dec 15, 2017 5:50 pm
One of the things that I don't quite understand... I had originally thought that factors were extracted by a mathematical technique called factor analysis. I've never been deeply enough into it to know offhand just how that works. It's similar, but not identical to principal components analysis, which I have done (i.e. written computer programs to do it). Principal components analysis takes a swarm of measurements of many different things. In the case of stocks it could be, say, the 600 monthly total return numbers of each individual stock for the last fifty years, treats them as points in multidimensional space, and asks "are these really scattered across 600 different dimensions?" Often they aren't, and by rotating the axes around you can arrange them so that one axis goes through the longest spread of the swarm, then you sweep the second axis around, staying at 90% to the first axis, until it transects the widest spread it can, and so forth. With luck, it may turn out that the whole swarm is really only one-dimensional, or two-dimensional, or three-dimensional, with a fairly small amount of noisy spread in the other directions. The first few dimensions capture almost all of the total variance of the swarm.

Now that sounds a lot like the way the factor mavens talk, but there's an important difference. The procedure for principal components analysis keeps the axes at 90° to each other. That is, the axes are constructed in such a way that there is always zero correlation between the projection of each point on the axes.

Apparently that's not what the financial factor investigators do. Apparently they simply define the factors in some plausible ad-hoc way, and then observe what the correlations are; and they aren't zero. They aren't independent. That is to say, if I have my head screwed on right, the momentum factor itself has a loading on the value factor, and so forth.

I don't know why they do it that way. That's just a statement. I'm not saying they're wrong, I'm saying I don't understand why they do it that way.
Right about factor analysis which this is not.

In this area of finance it is pretty clear factor just means "that which predicts return" in the sense of being a variable in a regression model that has some meaningful degree of explanatory power. This is just the word factor in the sense that all the Xi are factors in a formula like

Y = Ao + Sum (AiXi) for i = 1,n

When you do a regression like that one issue is what is the smallest set of factors that gives the best explanatory power. This can even be found out by the technique of stepwise regression. Another issue is the issue of selecting among factors that are correlated. The best thing is for the factors one ends up with not to be much correlated with each other and a lot of finagling with the model can occur in doing this. This is part of that business of why dividends, for example, don't usually get picked as factors. But unlike factor analysis, there is no attempt to find a new basis set of combinations of initial factors that gives a good explanation with factors that are all computed to be uncorrelated. At least that would be my understanding of it. I think the whole thing is less rather than more than meets the eye.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nedsaid » Fri Dec 15, 2017 6:14 pm

bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by lack_ey » Fri Dec 15, 2017 6:16 pm

nisiprius wrote:
Fri Dec 15, 2017 5:50 pm
One of the things that I don't quite understand... I had originally thought that factors were extracted by a mathematical technique called factor analysis. I've never been deeply enough into it to know offhand just how that works. It's similar, but not identical to principal components analysis, which I have done (i.e. written computer programs to do it). Principal components analysis takes a swarm of measurements of many different things. In the case of stocks it could be, say, the 600 monthly total return numbers of each individual stock for the last fifty years, treats them as points in multidimensional space, and asks "are these really scattered across 600 different dimensions?" Often they aren't, and by rotating the axes around you can arrange them so that one axis goes through the longest spread of the swarm, then you sweep the second axis around, staying at 90% to the first axis, until it transects the widest spread it can, and so forth. With luck, it may turn out that the whole swarm is really only one-dimensional, or two-dimensional, or three-dimensional, with a fairly small amount of noisy spread in the other directions. The first few dimensions capture almost all of the total variance of the swarm.

Now that sounds a lot like the way the factor mavens talk, but there's an important difference. The procedure for principal components analysis keeps the axes at 90° to each other. That is, the axes are constructed in such a way that there is always zero correlation between the projection of each point on the axes.

Apparently that's not what the financial factor investigators do. Apparently they simply define the factors in some plausible ad-hoc way, and then observe what the correlations are; and they aren't zero. They aren't independent. That is to say, if I have my head screwed on right, the momentum factor itself has a loading on the value factor, and so forth.

I don't know why they do it that way. That's just a statement. I'm not saying they're wrong, I'm saying I don't understand why they do it that way.
There are papers that do principal components analysis for securities returns and related matters, some who have constructed orthogonal factors to explain returns.

It's just that everybody generally prefers factors that are more cleanly defined (e.g. small stocks minus large stocks) rather than statistically separated. After all, factor definitions as they are can be formulated as actual investment strategies, they track with what managers have done, and already have narratives backing them. Sure, there are plenty of disagreements, and plenty of value definitions in the wild, but there is some kind of overlap with traditional practitioner phrasing and thinking.

Economically and financially we can kind of understand the difference between low volatility and high volatility stocks (and it's even clearer for some other examples like small vs. large). We can talk about the typical or average characteristics qualitatively and quantitatively. You could not say the same thing when doing a PCA looking at the 3rd axis or whatever—what even would that economically be related to? You could identify maybe something after the fact for one given analysis but it would not be as clean.

Furthermore, when you try to span one data set with some orthogonal components, you won't get the same exact components on a different data set. The factor definitions can be consistent from period to period and between markets.

It turns out that most of the equity model factors are not usually that dependent and correlated anyway (except profitability and quality being very related, if you take those separately), so it's not a huge deal.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by dbr » Fri Dec 15, 2017 6:21 pm

lack_ey wrote:
Fri Dec 15, 2017 6:16 pm

There are papers that do principal components analysis for securities returns and related matters, some who have constructed orthogonal factors to explain returns.

It's just that everybody generally prefers factors that are more cleanly defined (e.g. small stocks minus large stocks) rather than statistically separated. After all, factor definitions as they are can be formulated as actual investment strategies, they track with what managers have done, and already have narratives backing them.

Economically and financially we can kind of understand the difference between low volatility and high volatility stocks (and it's even clearer for some other examples like small vs. large), with qualitative and quantitative identification of the nature of these securities on average. You could not say the same thing when doing a PCA looking at the 3rd axis or whatever—what even would that economically be related to?

Furthermore, when you try to span one data set with some orthogonal components, you won't get the same exact components on a different data set. The factor definitions can be consistent from period to period and between markets.

It turns out that most of the equity model factors are not usually that dependent and correlated anyway (except profitability and quality being very related, if you take those separately), so it's not a huge deal.
I think that all makes sense. I am particularly struck by the point that it may be hard to interpret the meaning of what comes out as a principal component while ad hoc selection of financial variables that are conventional and understood makes a lot of sense. Finding components that are not consistent over time and data sets would be a messy outcome. Your last point would also seem to be supportive of keeping the analysis the way it is.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by bertilak » Fri Dec 15, 2017 6:36 pm

nedsaid wrote:
Fri Dec 15, 2017 6:14 pm
bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
I agree with that "Well, no" which is why I used the past tense (said ... in the past, not say now) and followed up with Swedroe's correction to that misconception (which, as mentioned, I accepted.) I COULD have mentioned Beta which is sort of the non-factor factor but that would have obfuscated the point. TSM, being cap-weighted, is NOT tilted in any way. It is the base-line from which actual tilts are measured. It's like saying vertical lines are "tilted" straight up, or tilted 0 degrees meaning not tilted at all. That's playing with semantics.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by siamond » Fri Dec 15, 2017 6:47 pm

lack_ey wrote:
Fri Dec 15, 2017 10:06 am
nisiprius wrote:
Fri Dec 15, 2017 9:23 am
I'm puzzled by this sentence:
Almost all investors are knowingly or unknowingly exposed to factors such as size, value, yield, momentum, and risk.
Two questions.

First, what on earth is meant by "risk?" Is risk, itself, a factor? Is that a mistake, and did they mean to say "the market factor?" Or has the problematical word "risk" acquired yet another inconsistent meaning?
Checking the paper very briefly, it seems like a reference to risk in the context of volatility, analyzing high risk vs. low risk stocks, low vol and low beta strategies, and similar constructions (start on page 30). It's not about overall stock market risk.

If you had a non-market allocation, you might have nontrivial exposure there in terms of being tilted to low volatility or the opposite, just as one of the others.
Yes, that's it. It's this extremely annoying habit of academics to equate risk with volatility. And then low volatility is one of the widely accepted factors (I never understood why this would make any common sense though).

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by triceratop » Fri Dec 15, 2017 7:07 pm

dbr wrote:
Fri Dec 15, 2017 6:21 pm
lack_ey wrote:
Fri Dec 15, 2017 6:16 pm

There are papers that do principal components analysis for securities returns and related matters, some who have constructed orthogonal factors to explain returns.

It's just that everybody generally prefers factors that are more cleanly defined (e.g. small stocks minus large stocks) rather than statistically separated. After all, factor definitions as they are can be formulated as actual investment strategies, they track with what managers have done, and already have narratives backing them.

Economically and financially we can kind of understand the difference between low volatility and high volatility stocks (and it's even clearer for some other examples like small vs. large), with qualitative and quantitative identification of the nature of these securities on average. You could not say the same thing when doing a PCA looking at the 3rd axis or whatever—what even would that economically be related to?

Furthermore, when you try to span one data set with some orthogonal components, you won't get the same exact components on a different data set. The factor definitions can be consistent from period to period and between markets.

It turns out that most of the equity model factors are not usually that dependent and correlated anyway (except profitability and quality being very related, if you take those separately), so it's not a huge deal.
I think that all makes sense. I am particularly struck by the point that it may be hard to interpret the meaning of what comes out as a principal component while ad hoc selection of financial variables that are conventional and understood makes a lot of sense. Finding components that are not consistent over time and data sets would be a messy outcome. Your last point would also seem to be supportive of keeping the analysis the way it is.
What's more, if factor mavens literally based their analysis on some orthogonal basis for the market there would be even more (justified!) claims that all that is occurring is data mining. What's nice is here there are definitions of clearly distinct economic factors with intuitive risks which when statistical analysis is performed result in mostly-orthogonal behavior.

(side note: a nice thing to define in a useful rigorous way would be the "orthogonality defect", the extent to which a basis fails to be orthogonal, which exists in other related contexts; this is not my specialty though)

At least, that is how I think about it. I like to think about factor investing as better than PCA.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by AlohaJoe » Fri Dec 15, 2017 7:53 pm

nisiprius wrote:
Fri Dec 15, 2017 11:21 am
But I don't have a non-market allocation.
Don't you? You're not holding the (global) market at global weight. So your factor exposure is 0.91 market, -0.21 size, -0.08 value, -0.05 momentum (and a ton of unexplained alpha!) according to PortfolioVisualizer.

I mean, whenever people talk about "US outperforming a global portfolio" they mean "I'm not holding a market portfolio and I am outperforming because of my factor loading", right?

(I've never understood why factors aren't measured relative to a global portfolio since, today, that's what people -- especially American investors with their highly developed investing infrastructure -- have as an investing option.)
Last edited by AlohaJoe on Fri Dec 15, 2017 10:00 pm, edited 1 time in total.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 8:47 pm

nedsaid wrote:
Fri Dec 15, 2017 6:14 pm
bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
The above is incorrect. The factors are constructed such that they are zero for the market and involve long and short positions. There is no small factor or value factor in the standard formulation. See. e.g., http://mba.tuck.dartmouth.edu/pages/fac ... loped.html

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by triceratop » Fri Dec 15, 2017 8:50 pm

rkhusky wrote:
Fri Dec 15, 2017 8:47 pm
nedsaid wrote:
Fri Dec 15, 2017 6:14 pm
bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
The above is incorrect. The factors are constructed such that they are zero for the market and involve long and short positions. There is no small factor or value factor in the standard formulation. See. e.g., http://mba.tuck.dartmouth.edu/pages/fac ... loped.html
I fail to see your point. You absolutely can get exposure (with a loading strictly less than 1) to SmB and HmL using long-only (index, too) funds. People call these the Small and Value factors. What is your specific objection?
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nedsaid » Fri Dec 15, 2017 8:59 pm

bertilak wrote:
Fri Dec 15, 2017 6:36 pm
nedsaid wrote:
Fri Dec 15, 2017 6:14 pm
bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
I agree with that "Well, no" which is why I used the past tense (said ... in the past, not say now) and followed up with Swedroe's correction to that misconception (which, as mentioned, I accepted.) I COULD have mentioned Beta which is sort of the non-factor factor but that would have obfuscated the point. TSM, being cap-weighted, is NOT tilted in any way. It is the base-line from which actual tilts are measured. It's like saying vertical lines are "tilted" straight up, or tilted 0 degrees meaning not tilted at all. That's playing with semantics.
What I have tried and apparently failed to say is that the indexes don't contain the bad stocks the academics rail against. Small Growth is the "black hole of investing" and yet when you look at the Vanguard Small Growth Index it performs as well as the Vanguard Small Value Index which should reflect investing nirvana. For one thing, the bad stocks, the lottery stocks, the anti-factors, or whatever you want to call them are not present in the Vanguard Small Growth Index. Secondly, Vanguard doesn't do the best job of screening for size and value, its Small Cap Value Index contains a lot of Mid-Cap and it contains a lot of Core Stocks.

Yes, Total Market by definition isn't tilted towards anything as it is the market. You can't help but notice that the largest 100 companies have as much market cap as the other 3,200 companies in the index. In my view, this bakes in Profitability/Quality into the Total Market cake though supposedly there are no tilts. 50% in 100 companies looks a lot like a tilt to my untrained eye. Furthermore, in the Small-Cap and Micro-Cap space, Total Market has to invest in stocks that have enough liquidity to be investable. The Wild West stocks found on the NASDAQ Bulletin Board are just not there. It seems that the academics include stocks in their research that the indexes don't touch.

I also mentioned above that the Size factor works great when you put it in with Profitability/Quality. With the bad stuff mixed in, the Small-Cap stocks have no premium over larger stocks. Screen for profitability, the premium returns with a vengeance. Again, I point to the example of the S&P 600 Small-Cap Index. Profitability/Quality also helps Value and if you set Momentum to neutral, Value is helped even more.

Pretty much, I am saying that the well constructed indexes have already screened for Profitability/Quality. They are not as factor neutral as you would think. Shoot, even Total Market is not, in my view, factor neutral as it has a big dash of Profitability/Quality. I am also saying that the lottery stocks are sort of like the Bogeyman. Responsible investors should not touch the lottery stocks and yet the academics include them in their research even though they are absent in the indexes. If you hold a good index, like the Total Market or the S&P 500, you have the good stuff and not the bad stuff. The S&P 400 Mid-Cap and the S&P 600 Small-Cap are also good indexes.

Even Beta has a low volatility tilt to it. I think what kicked off factor research were the findings that low volatility stocks performed better than predicted and that high volatility stocks performed worse than predicted. I suspect that Profitability/Quality was involved. If Beta really was Beta, then except for the extremes at each end, returns should have gone up with volatility but they did not. In fact, Low Volatility performs better than High Volatility.

I hope that someone more articulate than I will come riding to my rescue. This is more than semantics.
Last edited by nedsaid on Fri Dec 15, 2017 9:02 pm, edited 1 time in total.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nedsaid » Fri Dec 15, 2017 9:01 pm

rkhusky wrote:
Fri Dec 15, 2017 8:47 pm
nedsaid wrote:
Fri Dec 15, 2017 6:14 pm
bertilak wrote:
Fri Dec 15, 2017 3:28 pm

I have said something similar in the past: As a TSM investor I am exposed to ALL factors, even ones that haven't been discovered yet.
Well, no. What you have is a market portfolio where the factors are all cancelled out except for perhaps Profitability/Quality and maybe a whiff of momentum. You have exposure to the Market factor as you hold the index. Well constructed indexes, such as the S&P indexes screen out what I call the "anti-factors" or the lottery stocks. Stocks have to achieve certain quality measurements just to be included in the better indexes. Seeing that Total Market is skewed towards the mega-caps, you have exposure to Profitability/Quality, the top 100 companies by market cap are 50% of the Total Market Index. Because Total Market is essentially a Large Core with a tilt towards Large Growth, you don't have exposure to the Small factor or the Value factor. Momentum, at least as can be captured by investors, is mostly a Large Growth phenomenon. You might have a whiff of momentum exposure.

In Total Market, you have Small Stocks, Value Stocks, Momentum Stocks but not the factors. They mostly are cancelled out with the two exceptions that I mentioned above.

An example of this is the Small Cap effect, which in the whole universe of stocks, seems to have disappeared. When you use let's say the S&P Small-Cap 600 Index, the Small Cap effect returns with a vengeance as the very act of indexing has taken out the lottery stocks. S&P requires that stocks in their indexes be profitable, thus the act of indexing itself does some screening for you. This is one reason that indexing works well, the junk just isn't there. One reason Vanguard Small Growth Index does pretty well, no junk.
The above is incorrect. The factors are constructed such that they are zero for the market and involve long and short positions. There is no small factor or value factor in the standard formulation. See. e.g., http://mba.tuck.dartmouth.edu/pages/fac ... loped.html
Well, there is a Morningstar video out there where the example of the disappeared Small-Cap effect re-emerging with the S&P 600 Small-Cap Index is discussed. I didn't make this up. This was also discussed in another thread.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by rkhusky » Fri Dec 15, 2017 9:07 pm

nedsaid wrote:
Fri Dec 15, 2017 9:01 pm
Well, there is a Morningstar video out there where the example of the disappeared Small-Cap effect re-emerging with the S&P 600 Small-Cap Index is discussed. I didn't make this up. This was also discussed in another thread.
The small cap effect is not the same as the SmB factor in the Fama French factor model, although it is related. The SmB factor involves the difference in return between small and big stocks.

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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by nedsaid » Fri Dec 15, 2017 9:07 pm

triceratop wrote:
Fri Dec 15, 2017 8:50 pm

I fail to see your point. You absolutely can get exposure (with a loading strictly less than 1) to SmB and HmL using long-only (index, too) funds. People call these the Small and Value factors. What is your specific objection?
I think it is fair to say you can get better factor loading in a long/short situation than in a long only. Most all individual investors do not use shorting techniques and thus use long only funds to capture factors. Little guys like me don't have the scale to most effectively use shorting. Long only is not as efficient as long/short but it is also less costly and probably less risky.
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Re: Factor-Based Investing: The Long-Term Evidence - Dimson & Marsh

Post by triceratop » Fri Dec 15, 2017 9:08 pm

rkhusky wrote:
Fri Dec 15, 2017 9:07 pm
nedsaid wrote:
Fri Dec 15, 2017 9:01 pm
Well, there is a Morningstar video out there where the example of the disappeared Small-Cap effect re-emerging with the S&P 600 Small-Cap Index is discussed. I didn't make this up. This was also discussed in another thread.
The small cap effect is not the same as the SmB factor in the Fama French factor model, although it is related. The SmB factor involves the difference in return between small and big stocks.
The small cap effect is about outperformance relative to the market, no? Please explain how they differ in kind, not in degree.
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