Is Beta a distinct factor or a summation of other factors

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packer16
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Is Beta a distinct factor or a summation of other factors

Post by packer16 » Sat Dec 30, 2017 3:34 pm

How does one know if beta is a distinct factor versus just the summation of other factors weighted by the market at any given time? If it is distinct then it will provide diversification. If it is a summation, then factor investing is betting the market has it wrong in terms of weighting.

Packer
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Re: Is Beta a distinct factor or a summation of other factors

Post by KyleAAA » Sat Dec 30, 2017 3:42 pm

It is distinct in the multi-factor literature. I believe beta itself explains something like 80% of a portfolio’s variation and beta taken with size and value together collectively explain about 95%, from memory. My memory may be a bit off.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sat Dec 30, 2017 3:51 pm

I’m no academic expert but it would seem to me that factors are ways of categorizing and describing properties of assets. Value, momentum, etc exist in any asset including equities, bonds, commodities, currencies, real estate, etc so they aren’t exclusive to equities. Just as adjectives aren’t nouns but they are related. They also describe overlapping phenomena. You can split all equities into growth and value (ie expensive and cheap) but momentum stocks could be growth or value.

For investing purposes they are distinct sources of risk in the long short form and they don’t add up to the whole market. Value and growth equal 100%. Momentum would have to be included with non momentum to equal 100%. Profitability with non profitability, etc. Ture you would be more diversified holding both momentum and non momentum, but the goal is not to diversify across everything (that’s diworsification), rather it is to diversify across risk factors with a positive expected returns.
Last edited by betablocker on Sat Dec 30, 2017 4:03 pm, edited 1 time in total.

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Re: Is Beta a distinct factor or a summation of other factors

Post by stlutz » Sat Dec 30, 2017 4:02 pm

Risk factors are a way to measure systemic drivers of a security's return as distinct from stock-specific reasons.

Simply being a part of the stock market is an important driver of the returns of all stocks and chunks of the market. If the market doubles in value but nothing fundamentally changes with my company, my company's stock price will still go up substantially. So yes, "market beta" is a risk factor.

That said, one can assemble a risk model composed of any number of factors. I'm sure you could put one together that explains returns well that does not include market beta as one of the factors. I haven't actually tried it but I have little doubt it can be done. Whether that result would be a better way to explain reality would be an interesting debate.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sat Dec 30, 2017 4:04 pm

Stultz, you could also remove the market factor by going long short and isolate another factor.

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Re: Is Beta a distinct factor or a summation of other factors

Post by Random Walker » Sat Dec 30, 2017 4:21 pm

Packer wrote:
If it is a summation, then factor investing is betting the market has it wrong in terms of weighting.
I would never bet the market has it wrong, yet I’m pretty much all in on factors. The reason is that I believe that an efficient portfolio is a separate issue from an efficient market. Looking at a return v. SD plot, TSM can occupy a single point. One can with high likelihood create a portfolio including TSM that would land somewhere closer to the northwest than TSM alone.

Dave

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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Sun Dec 31, 2017 1:50 pm

The follow-up question I have is why is not the market weights the most efficient portfolio as the you have the weights of the market participants in your portfolio. It may not be right but it is the best estimate available. Is not any deviation saying you know more than the market that has put the weights on the stocks in the index in the first place? I can buy that there are specific situation where the market get the weights wrong but the factor approach is saying the market is systematically and cross sectionally getting it wrong, a large assumption no? I would buy your & the factor logic if there was some constraint on buying the factor stocks but to my knowledge there is not. So in other words you are getting an edge over index investors (why else would you invest that way) based upon data that is available to all and it easily invested by all. It sound more like Lake Wobegon than the way markets work.

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Re: Is Beta a distinct factor or a summation of other factors

Post by lack_ey » Sun Dec 31, 2017 2:48 pm

packer16 wrote:
Sat Dec 30, 2017 3:34 pm
How does one know if beta is a distinct factor versus just the summation of other factors weighted by the market at any given time? If it is distinct then it will provide diversification. If it is a summation, then factor investing is betting the market has it wrong in terms of weighting.

Packer
This depends on which factors you're talking about, how you define factors. If you mean academic factors used for pricing and return models like size, value, momentum, etc., then definitely the answer is no. If you have some kind of huge matrix of risk factors (including for example individual industry risks), then sure, maybe. I'm not quite able to follow what specifically you mean by a "summation." Maybe you're asking if it can be expressed as a linear combination of other factors? Sure, if the other factors span the market.

Definitionally by the academic factor model construction, the non-market factors are cross-sectional and don't have net investment, describing relative returns from groups of stocks. So with that class of models, the market factor, representing the return of the market (or market minus cash, depending on context) is definitely distinct, and there's no way you'll get close to it from a combination of the others.
packer16 wrote:
Sun Dec 31, 2017 1:50 pm
The follow-up question I have is why is not the market weights the most efficient portfolio as the you have the weights of the market participants in your portfolio. It may not be right but it is the best estimate available. Is not any deviation saying you know more than the market that has put the weights on the stocks in the index in the first place? I can buy that there are specific situation where the market get the weights wrong but the factor approach is saying the market is systematically and cross sectionally getting it wrong, a large assumption no? I would buy your & the factor logic if there was some constraint on buying the factor stocks but to my knowledge there is not. So in other words you are getting an edge over index investors (why else would you invest that way) based upon data that is available to all and it easily invested by all. It sound more like Lake Wobegon than the way markets work.

Packer
The most efficient portfolio depends on what you define as efficient.

But there are a lot of possible reasons why the market portfolio may not be the most efficient under just about any definition you use. Even if you assume informational efficiency in terms of stock pricing, that may not translate into the market being the most efficient portfolio, depending on how the pricing gets done, what the considerations are for incorporating that information. It's not like all investors agree on what their goals should be for investing (maximize return, best Sharpe ratio, etc.), so the aggregate behavior should not be assumed to be any particular ideal. Most professional investors don't and can't have expertise across the entire stock market. In fact if you look at the incentives of institutional investors, who play a large role in moving prices, these are not aligned with some optimal risk/return producing paradigm. We know that individual investors are not necessarily rational—the group may still be, roughly, but not necessarily.

So there are reasons to suspect pricing errors relative to what would make the market most efficient, conceptually. Some parts don't even require a departure from rational behavior.

If you assume the market is the most efficient, how would the behavior of underlying traders make it such? If the market is most efficient, if you underweight or overweight any stock, you will reduce efficiency. But how does the whole market get to be that way?

If you look empirically at past stock returns, there seem to be enough underlying issues that the market portfolio doesn't really seem ex-ante optimal in any sort of real way. It's not that you could have just invested in better-performing stocks to beat the market (good luck guessing those), but there seem to be patterns to exploit.

The academic factors help explain some of the past patterns, how some people did exploit certain things and come out ahead, like a Warren Buffett.

Factor investing is just one of the ways to attempt to improve portfolio efficiency according to certain desired characteristics, by systematically targeting some of the more well-established patterns (in terms of theoretical support, empirical evidence, and so on), hoping that they weren't just flukes, that the investing world hasn't changed to make them go away, and that they will continue to at least a modest extent in the future.

Keep in mind that even if the market is not most efficient, it could well be that a number of factor approaches going forward are less efficient. So this is not necessarily a strong argument for non-market investing. If you don't want to place relative bets, you can own the market for cheap, as a know-nothing investor, and you'll come out ahead of a lot of alternative approaches.

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Re: Is Beta a distinct factor or a summation of other factors

Post by patrick013 » Sun Dec 31, 2017 3:42 pm

If I had a separate SCV fund and put it into a model of 6 index
factors: LCG, LCV, MCG, MCV, SCG, SCV plus their multi-decade
returns on the side for reference the SCV fund should have the
highest statistical significance with the SCV index factor.

Putting the SCV fund into a single factor model with the SCV
index factor data I should get a higher beta than the multi
factor model as well as high statistical significance. I
suspect beta would be lower between the SCV fund and the SCV
index factor in the multi factor model because there are more
factors contributing but the statistical significance to be
obvious also with the SCV index factor.

The above isn't FF but does present size and value factors
and also growth. FF limits display to market, value, and
size, of course.

Can science make better portfolios or can art make better
portfolios just using expected returns while minimizing price
beta at the same time ? Or just go 100% with SCV.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sun Dec 31, 2017 4:06 pm

packer16 wrote:
Sun Dec 31, 2017 1:50 pm
The follow-up question I have is why is not the market weights the most efficient portfolio as the you have the weights of the market participants in your portfolio. It may not be right but it is the best estimate available. Is not any deviation saying you know more than the market that has put the weights on the stocks in the index in the first place? I can buy that there are specific situation where the market get the weights wrong but the factor approach is saying the market is systematically and cross sectionally getting it wrong, a large assumption no? I would buy your & the factor logic if there was some constraint on buying the factor stocks but to my knowledge there is not. So in other words you are getting an edge over index investors (why else would you invest that way) based upon data that is available to all and it easily invested by all. It sound more like Lake Wobegon than the way markets work.

Packer
Packer take a look at the literature on limits to arbitrage. Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance. Their customers don’t like when their managers underperform the market so those managers closet index. They give you a bit of the factor but essentially it’s market beta. See posts here about managed futures and commodities not working or watch the guys on CNBC halftime report. Commodities and managed futures go way up during the downturn and everyone rushes in. Then after it then underperforms everyone sells out. It happens right here on Bogleheads so you don’t need to go far for your evidence.

Another issue is that some strategies particularly momentum can’t take the amount of money that the managers want to put in them so as they increase their AUM the strategies just look more like the market. Those are both real limits and there are others as well.

Additionally there’s lots of behavioral research showing that when you present information to people with existing beliefs they discount it or evaluate it more skeptically than their existing beliefs. Again see this conversation and the constant back and forth on factors.

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Re: Is Beta a distinct factor or a summation of other factors

Post by Taylor Larimore » Sun Dec 31, 2017 4:19 pm

Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance.
betablocker:

What is your source?

Thank you and Happy New Year!
Taylor
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Re: Is Beta a distinct factor or a summation of other factors

Post by bigred77 » Sun Dec 31, 2017 4:21 pm

I overweight small and value because I'm trying to overweight higher risk, higher return (hopefully), higher standard deviation sub-populations of the overall market that will hopefully be relatively non-correlated to the other parts of my portfolio. I don't think that means I'm conceding the overall market to be inefficient. I just prefer to overweight the riskier slices of the equity market and hope that they don't all zig and zag in unison.

I believe in diversifying across different academically researched sources of return. To be fair, I'm not exactly all in because I understand and believe in the small and value factors but I'm not quite sold on momentum and other factors. I also have a moderate tilt. The majority (2/3) of my equities are in plain old total market index funds.

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Re: Is Beta a distinct factor or a summation of other factors

Post by alex_686 » Sun Dec 31, 2017 4:29 pm

Beta is not a facgtor or summation of factors. It is a performance risk measure. Beta compares your portfolio's volility against the index. If you have a small value portfolio then your index is a small value portfolio. Beta tells your how much of your performance is from the market - the index. There are easy ways to get Beta. Invest in a index. Want a Beta of 1.5? Load up on margin. Want a Beta of 2? Load up on futures.

The opposite of Beta is Alpha. Alpha is the return generated from the portfolio manager's skill.

To put it another way, you chosen thhe factors and leverage that you want to be exposed to. Beta is what the market gives, Alphha is from skill.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sun Dec 31, 2017 6:08 pm

Taylor Larimore wrote:
Sun Dec 31, 2017 4:19 pm
Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance.
betablocker:

What is your source?

Thank you and Happy New Year!
Taylor
This was a key paper from 1995 on the limits to arbitrage: http://www.nber.org/papers/w5167.pdf. Often cited indirectly by Larry as well when he refers to limits to arbitrage. You can also read diy financial advisor from Wes Gray at Alpha Architect which ties the concept to particular factors or there are several blogs and white papers they’ve written on the topic.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sun Dec 31, 2017 6:15 pm

alex_686 wrote:
Sun Dec 31, 2017 4:29 pm
Beta is not a facgtor or summation of factors. It is a performance risk measure. Beta compares your portfolio's volility against the index. If you have a small value portfolio then your index is a small value portfolio. Beta tells your how much of your performance is from the market - the index. There are easy ways to get Beta. Invest in a index. Want a Beta of 1.5? Load up on margin. Want a Beta of 2? Load up on futures.

The opposite of Beta is Alpha. Alpha is the return generated from the portfolio manager's skill.

To put it another way, you chosen thhe factors and leverage that you want to be exposed to. Beta is what the market gives, Alphha is from skill.
I think OP was talking about the market factor often called market beta. That is a factor. Is the beta of a small cap value fund measured against a SCV index? I assume you could calculate it for either but isn’t the “beta” most people are referring to measuring against the total market return rather than the scv subset? Curious to know if that isn’t right.

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Re: Is Beta a distinct factor or a summation of other factors

Post by Taylor Larimore » Sun Dec 31, 2017 8:38 pm

betablocker wrote:
Sun Dec 31, 2017 6:08 pm
Taylor Larimore wrote:
Sun Dec 31, 2017 4:19 pm
Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance.
betablocker:

What is your source?

Thank you and Happy New Year!
Taylor
This was a key paper from 1995 on the limits to arbitrage: http://www.nber.org/papers/w5167.pdf. Often cited indirectly by Larry as well when he refers to limits to arbitrage. You can also read diy financial advisor from Wes Gray at Alpha Architect which ties the concept to particular factors or there are several blogs and white papers they’ve written on the topic.
betablocker:

Thank you for the 27 page "paper." I read it with interest but I could not find anything suggesting that "Big asset managers know that factors will outperform in the long term."

This article may be of interest:

Passive Investing:. If it's good enough for Calpers . . .

Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Is Beta a distinct factor or a summation of other factors

Post by alex_686 » Sun Dec 31, 2017 9:37 pm

betablocker wrote:
Sun Dec 31, 2017 6:15 pm
I think OP was talking about the market factor often called market beta. That is a factor. Is the beta of a small cap value fund measured against a SCV index? I assume you could calculate it for either but isn’t the “beta” most people are referring to measuring against the total market return rather than the scv subset? Curious to know if that isn’t right.
If they are they are either doing it wrong or being lazy. Maybe both. Everybody uses the S&P 500 as "The Market" because it is a popular and pretty solid data set. And that is fine as long as "The Market" is Large Cap US stocks - which for most people it is. However it you included other things, small cap or international, you can't use the S&P 500 as "The Market" for your Beta.

Beta is a relative risk adjusted measure of portfolio performance. It tries to answer how portfolio X is doing against index Y. The most correct way of doing things is to create a custom index in your ISP - for example a blend of the 3 fund indexes and use that.

You can't ask what a small cap index's Beta is against a large cap index. It is like asking compare apples to organizes. You can run thhe numbers but you are going to get garbage. You need to use a different tool - maybe a Sharpe ratio or something.

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Re: Is Beta a distinct factor or a summation of other factors

Post by Robert T » Sun Dec 31, 2017 9:54 pm

.
The Capital Asset Pricing Model (CAPM) says that the only measure of risk that matters in explaining average returns of any equity portfolio is its sensitivity to market volatility i.e. Beta.

However, as research has shown, sensitivity to market volatility (beta) is not the only risk that matters. It only explains about 70 percent of the variability in returns (averaged across different types of equity portfolios).

Fama-French extended the CAPM, saying that at least two more risk factors are needed, beyond beta, to explain how average returns across equity portfolios differ from one another. Their three factor model that includes beta, size and value factors explains about 95 percent of the variability in returns (averaged across different types of equity portfolios).

While not perfect, the Fama-French three factor model does a better jobs than the CAPM at explaining the variability in portfolio returns (across different types of portfolios).
.
Last edited by Robert T on Sun Dec 31, 2017 9:59 pm, edited 1 time in total.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Sun Dec 31, 2017 9:55 pm

Taylor Larimore wrote:
Sun Dec 31, 2017 8:38 pm
betablocker wrote:
Sun Dec 31, 2017 6:08 pm
Taylor Larimore wrote:
Sun Dec 31, 2017 4:19 pm
Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance.
betablocker:

What is your source?

Thank you and Happy New Year!
Taylor
This was a key paper from 1995 on the limits to arbitrage: http://www.nber.org/papers/w5167.pdf. Often cited indirectly by Larry as well when he refers to limits to arbitrage. You can also read diy financial advisor from Wes Gray at Alpha Architect which ties the concept to particular factors or there are several blogs and white papers they’ve written on the topic.
betablocker:

Thank you for the 27 page "paper." I read it with interest but I could not find anything suggesting that "Big asset managers know that factors will outperform in the long term."

This article may be of interest:

Passive Investing:. If it's good enough for Calpers . . .

Best wishes.
Taylor
If you read the implications part of the paper, it clearly says exactly what I said but i’m increasingly understanding that research or evidence isn’t going to change any minds that are made up. The 3 fund portfolio is great and bogleheads has many things to teach. I’m thankful for all of that. Unfortunately though, I don’t think further exchanges of views on this topic will yield much of anything. We’re not operating from the same first principles so unless i’m willing to say that all the academic evidence is wrong or you’re willing to say that simplicity and low cost aren’t the only criteria worth evaluating, the rest is pointless sparing. We can agree to disagree and happy new year! I’m sure our loved ones care much less about this than we do.

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Re: Is Beta a distinct factor or a summation of other factors

Post by patrick013 » Sun Dec 31, 2017 10:08 pm

Robert T wrote:
Sun Dec 31, 2017 9:54 pm
.
The Capital Asset Pricing Model (CAPM) says that the only measure of risk that matters in explaining average returns of any equity portfolio is its sensitivity to market volatility i.e. Beta.

However, as research has shown, sensitivity to market volatility (beta) is not the only risk that matters. It only explains about 70 percent of the variability in returns (averaged across different types of equity portfolios).

Fama-French extended the CAPM, saying that at least two more risk factors are needed, beyond beta, to explain how average returns across equity portfolios differ from one another. Their three factor model that includes beta, size and value factors explains about 95 percent of the variability in returns (averaged across different types of equity portfolios).

While not perfect, the Fama-French three factor model does a better jobs than the CAPM at explaining the variability in portfolio returns (across different types of portfolios).
.
If you really want my opinion neither one of them is any good. Return beta
is also inferior as part of the scheme. Concepts are supposed to be viewed
as concepts, price beta is supposed to be viewed as daily price beta. Ever see an
efficient frontier based on price beta rather than old yucky std deviation.
Some thing has to change.
age in bonds, buy-and-hold, 10 year business cycle

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Taylor Larimore
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Definition of "Beta"

Post by Taylor Larimore » Sun Dec 31, 2017 10:34 pm

Bogleheads:

It helps to know what we are talking about:

Investopedia:
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole.
Best wishes.
Taylor
"Simplicity is the master key to financial success." -- Jack Bogle

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Re: Is Beta a distinct factor or a summation of other factors

Post by privatefarmer » Mon Jan 01, 2018 3:54 am

bigred77 wrote:
Sun Dec 31, 2017 4:21 pm
I overweight small and value because I'm trying to overweight higher risk, higher return (hopefully), higher standard deviation sub-populations of the overall market that will hopefully be relatively non-correlated to the other parts of my portfolio. I don't think that means I'm conceding the overall market to be inefficient. I just prefer to overweight the riskier slices of the equity market and hope that they don't all zig and zag in unison.

I believe in diversifying across different academically researched sources of return. To be fair, I'm not exactly all in because I understand and believe in the small and value factors but I'm not quite sold on momentum and other factors. I also have a moderate tilt. The majority (2/3) of my equities are in plain old total market index funds.
my thoughts exactly. I see it similar as using leverage. you can increase your risk by using leverage or you can buy smaller/valuey stocks. in fact, value stocks tend to have more debt so in a sense they are higher leveraged. doesn't mean it's more efficient than TSM, it may have a LOWER risk-adjusted return, but if you want more $$$ in the end you have to take more risk one way or another.

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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Mon Jan 01, 2018 10:07 am

Thanks for the replies. Although the paper referenced dose have some interesting point it is dated (1995) & alot of money has flowed into factor strategies since then. One issue I am having with the factor model is the how investing in a factor way will not reduce its benefits to almost zero as the factor investing approach will be incorporated into prices. I think one Boglehead concept that is implicit is that markets are approaching efficiency.

I have found an interesting framework of market efficiency that is applicable here. In the "Pitch the Perfect Investment", market efficiency is broken into three phases. The first is dissemination of information. The second is processing of information & the third is incorporation of information into prices. Now if we apply this to factors then it would appear that factors are incorporated into prices as the framework has been disseminated, processed & incorporated into prices so the advantages of factors seen in the past data should not be expected going forward. If you want to find a framework that adds value you need to find situations where there are issue with dissemination, processing or incorporation of information into prices. I do not see factors as a framework that does this anymore.

Packer
Last edited by packer16 on Mon Jan 01, 2018 10:18 am, edited 1 time in total.
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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Mon Jan 01, 2018 10:18 am

Packer, I’d agree that factors can be overbought. Low Vol is a good example but this is cyclical as well. I’d agree for value if we saw the spreads between expensive and cheap narrow but they are at historic norms suggesting value is not expensive. The evidence for momentum has been available for 100s of years. Again this is why we diversify across factors. You’d also have to explain away the fools on CNBC. People buy the stuff they recommend.

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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Mon Jan 01, 2018 10:35 am

You have to be careful on the value/growth spread. The implicit assumption there is the quality of the firms have value characteristics are the same as in the past. I would argue that it has changed over time as the market has become more efficient (ie. the value stocks compared to growth stock have become crappier). I have noticed this historically as more recent value screens have included more declining revenue highly leveraged firms. So the spread needs to adjusted for firm quality to say whether the large spread is justified & will revert to the mean or not.

Another issue with factors is I see them as akin to a zero sum game. So if you win someone else loses so for factors to continue to perform as they have in the past you need to have a group of losers. Who are these losers as more & more losers are walking away from the game via indexing. So how is factor investing any different from any other active strategy with non-professionals competing against the pros? As to diversification, are you not just diversifying across active strategies all playing a zero sum game? And isn't one the appeals of Bogleheads to get away from playing zero sum games?

Packer
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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Mon Jan 01, 2018 11:01 am

I’d be wary of drawing conclusions based on some screens. One reason those companies might be more in debt is that debt is cheap so it is very rational to do so. Many value processes screen for quality measures as well. But in the end there is some element of risk involved in value the question is is the market pricing it efficiently and the limits to arbitrage show reasons why it might not be.

As for the zero sum game I agree. It is extremely important to know who is in the other side of the trade. If there weren’t limits to arbitrage there wouldn’t be the premium. Reality is there are groups of uniformed investors who trade off CNBC recommendations and informed investors who don’t by value because it will underperform. Maybe indexing changes this over time. It’s still a low part of the market and also loosely defined. I suspect there are many “indexers” who are closet active traders jumping in and out of indices. Also wait until the S&p underperforms. We’ll see how many stick to the plan then. This has all happened before and it will all happen again.

As for active I think this is largely a semantic debate. If you mean active to be high fee or bottoms up stock selection I agree. The evidence shows that doesn’t work. But almost everyone is active in some way. Three fund with no international is an active bet. Three fund that doesn’t hold equities at their world market cap is an active bet. Market beta is a factor just like momentum. Essentially everyone is active at some point as they deviate from global market cap. The question is are you systematic, lowering costs, and doing things based on robust and well researched evidence. I don’t think 3 fund is wrong. It is one way to do that.

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Re: Is Beta a distinct factor or a summation of other factors

Post by longinvest » Mon Jan 01, 2018 11:03 am

Packer,

I think that you're onto something, here.
packer16 wrote:
Mon Jan 01, 2018 10:35 am
So how is factor investing any different from any other active strategy with non-professionals competing against the pros?
Based on the mathematical definition of active and passive, before "passive" was redefined by active firms to mean something else than "cap-weighted indexing", factor investing is a form of active investing.
packer16 wrote:
Mon Jan 01, 2018 10:35 am
And isn't one the appeals of Bogleheads to get away from playing zero sum games?
Bogleheads are a diverse group, so I can't talk for others. But, me, I only invest into total-market cap-weighted index ETFs. I'm not interested in trying to juice up returns using factors, tilting, and whatever. I'm satisfied with the returns of my balanced portfolio. I've just made sure to live below my means allowing me to save enough to meet my financial objectives without needing to beat the various markets I invest into.
Bogleheads investment philosophy | Lifelong Portfolio: 25% each of (domestic/international)stocks/(nominal/inflation-indexed)bonds | VCN/VXC/VLB/ZRR

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packer16
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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Mon Jan 01, 2018 11:21 am

I agree about knowing who you are trading against & therefore factors have little influence on my strategy. My approach is more about finding the exceptions on the edge that have type of constraint against efficiency versus a cross-sectional approach of factors that by definition you will not know who is other side of the trade. IMO factors are known & widely invested in so why would they be better than a market cap index? If you want more risk lever up the index versus using SCV which is not as reliable.

As to stock selection, I think it can work if you are using a different model than other participants & you are correct. The main issue is when many folks are using very similar models. If you are using a different model, you have a variant perspective.

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Re: Is Beta a distinct factor or a summation of other factors

Post by lack_ey » Mon Jan 01, 2018 12:13 pm

packer16 wrote:
Mon Jan 01, 2018 10:07 am
Thanks for the replies. Although the paper referenced dose have some interesting point it is dated (1995) & alot of money has flowed into factor strategies since then. One issue I am having with the factor model is the how investing in a factor way will not reduce its benefits to almost zero as the factor investing approach will be incorporated into prices. I think one Boglehead concept that is implicit is that markets are approaching efficiency.

I have found an interesting framework of market efficiency that is applicable here. In the "Pitch the Perfect Investment", market efficiency is broken into three phases. The first is dissemination of information. The second is processing of information & the third is incorporation of information into prices. Now if we apply this to factors then it would appear that factors are incorporated into prices as the framework has been disseminated, processed & incorporated into prices so the advantages of factors seen in the past data should not be expected going forward. If you want to find a framework that adds value you need to find situations where there are issue with dissemination, processing or incorporation of information into prices. I do not see factors as a framework that does this anymore.

Packer
It's still expensive and risky to short certain stocks, still there are frictions, etc. The length of time (and uncertainty of it) to get convergence on a lot of trades is too high for many to exploit reasonably, especially resulting from career considerations, where managers are evaluated on time periods that are too short. I mean, there's even empirical evidence of underperforming active managers trying to catch up in the rest of the calendar year by making riskier moves, increasing volatility.


More importantly, to make sure I'm understanding things, are you saying that stocks should have equivalent expected returns? Or risk-adjusted returns? Or that the returns should fall in line with what would make the market portfolio the most efficient?

Some stocks are empirically and theoretically should be riskier than others. Do you think there is any way to identify them ahead of time, and what should their return be?

In other words, what is priced in and why?

Tanelorn
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Re: Is Beta a distinct factor or a summation of other factors

Post by Tanelorn » Mon Jan 01, 2018 12:31 pm

This has bothered me about factors as a source of returns rather than just using them as risk models.
lack_ey wrote:
Mon Jan 01, 2018 12:13 pm
In other words, what is priced in and why?
Not to speak for Packer, but if you have all these well known factors like Value, Size, etc, with decades of academic research, why would they deliver outperformance? I guess it could be you're taking a different kind of risk, like tail risks of longer term underperformance, bigger tail risks that most people don't want (bad skew, etc), or the like. Still, absent some convincing economic or behavioral explanation, I would think that the risk-adjusted returns of factor investing would be similar to the market overall, and posssibly a bit lower if they offer a diversification benefit, and if you believe that, taking more risk is better via leverage of the market portfolio than via high risk factor bets. The discussion of zero sum games is relevant here.

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Re: Is Beta a distinct factor or a summation of other factors

Post by lack_ey » Mon Jan 01, 2018 12:54 pm

Tanelorn wrote:
Mon Jan 01, 2018 12:31 pm
This has bothered me about factors as a source of returns rather than just using them as risk models.
lack_ey wrote:
Mon Jan 01, 2018 12:13 pm
In other words, what is priced in and why?
Not to speak for Packer, but if you have all these well known factors like Value, Size, etc, with decades of academic research, why would they deliver outperformance? I guess it could be you're taking a different kind of risk, like tail risks of longer term underperformance, bigger tail risks that most people don't want (bad skew, etc), or the like. Still, absent some convincing economic or behavioral explanation, I would think that the risk-adjusted returns of factor investing would be similar to the market overall, and posssibly a bit lower if they offer a diversification benefit, and if you believe that, taking more risk is better via leverage of the market portfolio than via high risk factor bets. The discussion of zero sum games is relevant here.
Not all stocks should have the same discount rate because their properties and risks are not the same. The question is about the magnitude of the differences. There are additional questions about how the differences are priced in and by how much, if it's even rational, if there are any freebies to be had.

It doesn't matter whether you understand the risks of certain stocks as size factor or anything else, that it's been understood or written about, etc. If as before riskier stocks are understood as riskier and priced accordingly, that should continue. How is that going to be priced away?

But let's say the market has a Sharpe ratio of 0.40. Then a tilted factor portfolio with certain factors has a Sharpe ratio of 0.37, with 1.5x the volatility. Does that look reasonable to you? I think others would imagine the forward returns of certain factor portfolios to have better risk/return than the market, especially if there are remaining behavioral errors or other mispricings resulting from bad incentives or otherwise not optimizing for Sharpe or some other measure (let's say maybe a low-vol portfolio can have a Sharpe ratio of 0.45 though with lower expected return). That said, for the purposes of this example let's just assume you can't get higher risk/return from a tilted portfolio.

In this case, this effectively is like leverage, but worse than if you could actually leverage at the risk-free rate. But seeing as you can't, at least not at T-bills (somewhere around 3-month LIBOR or a bit above that, sure), this is better than real-life leverage and without the need to manage leverage rebalancing etc. And in a whole portfolio context, I'd rather have 40% tilted stocks with 60% bonds, than 60% market stocks with 40% bonds. You might get slightly higher return for lower risk in the former.


The extent to which factors deliver excess returns above the level justified by potentially extra risk and better risk/return than you'd expect—that may likely diminish, though it will depend on what exactly caused the prior behavior and how much of those underlying conditions still hold in the future, and how well the mispricing (supposing it exists) can be corrected. Some identified factors rely on behavioral or structural errors, while others may not. But even the former could persist for a number of reasons.

Factor investing is not about making high-confidence bets. I don't think it's predicated on strong beliefs, just an insistence that there's a substantial, non-negligible chance some of the factors continue to work (in some sense, depending on the exact goals and construction) in some capacity.

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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Mon Jan 01, 2018 12:59 pm

I am saying that the market will price on average the risks in stocks appropriately so, unless you have specific information about a specific security that is not incorporated into price, the best estimate of value is the market price & thus tilting will not add anything but volatility unless yon can time how the factors will be realized. The past data we have seen I think shows this. The fallacy many fall into is looking at the periods where factors were not known & heavily invested in.

What some appear to believe that the market is not smart enough to price securities on a relative basis that include the effects of factors & by weighting a portfolio differently (by factors) you will get a benefit that is not available via the normal relative weighting of securities.

I think factors may work but is the margin by how much they will work more than offset by the more volatility they introduce & is the outperformance more than just levering up the market portfolio? If not, then factor is investing is another form of active investing & subject to the same erosion over time until its edge is no more than cost to implement it.


Packer
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Re: Is Beta a distinct factor or a summation of other factors

Post by Lauren Vignec » Mon Jan 01, 2018 1:25 pm

packer16 wrote:
Mon Jan 01, 2018 12:59 pm
I am saying that the market will price on average the risks in stocks appropriately so, unless you have specific information about a specific security that is not incorporated into price, the best estimate of value is the market price & thus tilting will not add anything but volatility unless yon can time how the factors will be realized. The past data we have seen I think shows this. The fallacy many fall into is looking at the periods where factors were not known & heavily invested in.

What some appear to believe that the market is not smart enough to price securities on a relative basis that include the effects of factors & by weighting a portfolio differently (by factors) you will get a benefit that is not available via the normal relative weighting of securities.

I think factors may work but is the margin by how much they will work more than offset by the more volatility they introduce & is the outperformance more than just levering up the market portfolio? If not, then factor is investing is another form of active investing & subject to the same erosion over time until its edge is no more than cost to implement it.


Packer
Hi Packer,

What matters is to what extent value and small will be correlated with the market. No matter how smart the market is, there can be benefits to diversification by factors other than market if those factors are poorly correlated with the market. That's just math.

It's easy to imagine the benefits of less-than-perfect correlations being over-estimated by people who rely on back-tests. It's also easy to imagine why small stocks might not be perfectly correlated with the market, which is so dominated by large stocks that it is pretty much just "large". However, an only slightly imperfect correlation isn't going to do much for an investor.

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Re: Is Beta a distinct factor or a summation of other factors

Post by lack_ey » Mon Jan 01, 2018 1:28 pm

packer16 wrote:
Mon Jan 01, 2018 12:59 pm
I am saying that the market will price on average the risks in stocks appropriately so, unless you have specific information about a specific security that is not incorporated into price, the best estimate of value is the market price & thus tilting will not add anything but volatility unless yon can time how the factors will be realized. The past data we have seen I think shows this. The fallacy many fall into is looking at the periods where factors were not known & heavily invested in.

What some appear to believe that the market is not smart enough to price securities on a relative basis that include the effects of factors & by weighting a portfolio differently (by factors) you will get a benefit that is not available via the normal relative weighting of securities.
I'm sorry to keep asking, but you seem to keep glossing over important distinctions, ones that could help clarify all of our thinking and help answer your questions. If you're not precise enough, we'll keep talking past each other. Maybe I'm messing up as well

Supposing as you state that the best estimate of value is the market price, what is this value? Again, does it result in the market being the optimal risk/return portfolio (with risk defined how)? What are the properties of return for different stocks?

You suggest that the market is pricing in factors such that there's not a way to get a benefit not available through "normal relative weighting of securities" (which I assume to mean market cap weighting). But how could all this be simultaneously possible, in a broad sense, for every potential benefit? Let's say I want an all-stock portfolio but want it to be less volatile (perhaps at the expense of lower return). Is this possible? Is it possible for me to come up with an allocation that is more positively skewed than the market? More negatively skewed?

I would say that certain properties of stocks are more useful to some participants than others. Managers with a stock-only portfolio to run may push prices in a different way than balanced stock/bond managers might (though in practice, most balanced funds are run by separate stock and bond teams). Who is correct? People stay within their areas of expertise, mostly. What is the mechanism by which all these different needs and pricing pressures result in what you think is the market pricing all of the factors into doing [what is it here]?

Whatever you think of the way stock pricing works, we've empirically seen even examples of money managed under index or other mandates seemingly providing opportunities for other investors. What does it mean for Russell 2000 funds to have gotten frontrun? Why have fallen angel bonds delivered notably better risk/return than BBB-rated corporate bonds and other junk bonds? What does this mean in the context of the market incorporating everything into prices? If there are some structural inefficiencies (or whatever you would prefer to call these) that are possible in markets, why not some others, on different scales?


packer16 wrote:
Mon Jan 01, 2018 12:59 pm
I think factors may work but is the margin by how much they will work more than offset by the more volatility they introduce & is the outperformance more than just levering up the market portfolio? If not, then factor is investing is another form of active investing & subject to the same erosion over time until its edge is no more than cost to implement it.
Some factor portfolios have less volatility.

Factor investing is active investing in the sense of deviating from the market. In fact, it's basically just systemic or rules-based active, specifically a way to replicate some key characteristics of traditional active managers' active return (return of portfolio minus return of benchmark). With factor funds you can deviate from the market in a more predictable and controlled fashion, hopefully with lower costs than other active approaches. You don't get the effect of idiosyncratic judgments and stock picking, which is either a positive or a negative from a given manager, depending on your perspective.

Of course it's subject to potential erosion, as everything else is. These just represent some of the best-known ways to tilt and try to exploit some past patterns.

But what is the edge, exactly?

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Re: Is Beta a distinct factor or a summation of other factors

Post by garlandwhizzer » Mon Jan 01, 2018 1:58 pm

Great discussion by some of our most knowledgeable members on both sides of this question.

Garland Whizzer

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Re: Is Beta a distinct factor or a summation of other factors

Post by stlutz » Mon Jan 01, 2018 2:18 pm

I am saying that the market will price on average the risks in stocks appropriately so, unless you have specific information about a specific security that is not incorporated into price, the best estimate of value is the market price
packer: Although I'm sympathetic with your understanding, I think you're wandering into the area of assuming the conclusion to be true (markets are rational/efficient) and then arguing that countervailing evidence isn't relevant.

I think through all of our discussions over the years, we really have come to agreement that there is long-term (e.g. past 80 years or so) historical outperformance for value. Not everybody agrees, but the evidence in the threads points that way.

I know this is more controversial, but I think the threads have also shown that "risk" (and thus efficient markets) is not a good explanation for this effect. We have certainly demonstrated that value companies have certain risks that are peculiar to them. The same is true of growth stocks. However, over most time periods, value is usually at least somewhat less volatile than growth, which makes it look even better from a Sharpe ratio perspective. Regardless of the data, in order for there to be a risk premium, there must be a rational reason for most investors (dollar weighted) to prefer growth stocks despite that fact that they will underperform. We've never found that. We've found irrational reasons for this to be the case, but that puts you into the territory of anomalies as opposed to rational pricing.

So, we get to the point of concluding that there was in fact mis-pricing historically. Why that was is a matter of debate (and is ground we probably haven't covered enough as we've spent all of our time on the "risk" question). The paper that betablocker linked is interesting in that it basically argues for a characteristics driven-anomaly (the market has incorrectly projected firms' past growth into the future) but it hasn't fixed the problem because there have been other anomalies that could get get captured more reliably such that there hasn't been enough money available to attack the value anomaly. I'm not sure how you collect evidence to demonstrate or falsify that approach, but it's an interesting way to look at the issue.

I think "smart beta" is interesting to consider in light of this as it's somewhat of a move away from style-based investing. We've had value and growth funds for a long time, and the traditional "diversified" way to approach it has been to find a good value manger, find a good growth manager, split your funds equally between the two, and roll in the profits (or lack thereof because of the fees/expenses). Style-based investing didn't lead to systematically trying to focus only on investment styles that mostly seem to work.

Smart beta doesn't have an opposite in terms of funds--with this approach you are systematically going after historical return factors without balancing them out through holding funds doing the opposite. This is a subtle shift that's not relying on arbitrage investors nor is it depending on a small number of hedge funds--it's getting adopted pretty broadly. This approach certainly has the potential to reduce/eliminate/reverse historical return premiums. Whether that has happened, it's hard to say.

What we need is an analysis to determine what kind of net shift to smart beta (dollar wise) has to occur to eliminate the premium and then determine to what extent that shift has occurred. Both very difficult numbers to arrive at. But I really wish some academic researchers would pursue this question vs. running another backtest to find some "new" factor that worked historically.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Mon Jan 01, 2018 2:27 pm

Tanelorn wrote:
Mon Jan 01, 2018 12:31 pm
This has bothered me about factors as a source of returns rather than just using them as risk models.
lack_ey wrote:
Mon Jan 01, 2018 12:13 pm
In other words, what is priced in and why?
Not to speak for Packer, but if you have all these well known factors like Value, Size, etc, with decades of academic research, why would they deliver outperformance? I guess it could be you're taking a different kind of risk, like tail risks of longer term underperformance, bigger tail risks that most people don't want (bad skew, etc), or the like. Still, absent some convincing economic or behavioral explanation, I would think that the risk-adjusted returns of factor investing would be similar to the market overall, and posssibly a bit lower if they offer a diversification benefit, and if you believe that, taking more risk is better via leverage of the market portfolio than via high risk factor bets. The discussion of zero sum games is relevant here.
Levering an exposure to one factor (market beta) does not have the same risk adjusted return as a portfolio invested in several low or negatively correlated factors. The levered market bet is far more risky with a lower return.

See above on limits to arbitrage paper and there are dozens of papers, articles, etc. that show various behavioral and risk based reasons for factor returns and why they persist. People knew about the value factor last fall/early winter when it went through the roof. They also knew about it in 2002. DFA has been around for a long time.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Mon Jan 01, 2018 3:12 pm

stlutz wrote:
Mon Jan 01, 2018 2:18 pm
I am saying that the market will price on average the risks in stocks appropriately so, unless you have specific information about a specific security that is not incorporated into price, the best estimate of value is the market price
packer: Although I'm sympathetic with your understanding, I think you're wandering into the area of assuming the conclusion to be true (markets are rational/efficient) and then arguing that countervailing evidence isn't relevant.

I think through all of our discussions over the years, we really have come to agreement that there is long-term (e.g. past 80 years or so) historical outperformance for value. Not everybody agrees, but the evidence in the threads points that way.

I know this is more controversial, but I think the threads have also shown that "risk" (and thus efficient markets) is not a good explanation for this effect. We have certainly demonstrated that value companies have certain risks that are peculiar to them. The same is true of growth stocks. However, over most time periods, value is usually at least somewhat less volatile than growth, which makes it look even better from a Sharpe ratio perspective. Regardless of the data, in order for there to be a risk premium, there must be a rational reason for most investors (dollar weighted) to prefer growth stocks despite that fact that they will underperform. We've never found that. We've found irrational reasons for this to be the case, but that puts you into the territory of anomalies as opposed to rational pricing.

So, we get to the point of concluding that there was in fact mis-pricing historically. Why that was is a matter of debate (and is ground we probably haven't covered enough as we've spent all of our time on the "risk" question). The paper that betablocker linked is interesting in that it basically argues for a characteristics driven-anomaly (the market has incorrectly projected firms' past growth into the future) but it hasn't fixed the problem because there have been other anomalies that could get get captured more reliably such that there hasn't been enough money available to attack the value anomaly. I'm not sure how you collect evidence to demonstrate or falsify that approach, but it's an interesting way to look at the issue.

I think "smart beta" is interesting to consider in light of this as it's somewhat of a move away from style-based investing. We've had value and growth funds for a long time, and the traditional "diversified" way to approach it has been to find a good value manger, find a good growth manager, split your funds equally between the two, and roll in the profits (or lack thereof because of the fees/expenses). Style-based investing didn't lead to systematically trying to focus only on investment styles that mostly seem to work.

Smart beta doesn't have an opposite in terms of funds--with this approach you are systematically going after historical return factors without balancing them out through holding funds doing the opposite. This is a subtle shift that's not relying on arbitrage investors nor is it depending on a small number of hedge funds--it's getting adopted pretty broadly. This approach certainly has the potential to reduce/eliminate/reverse historical return premiums. Whether that has happened, it's hard to say.

What we need is an analysis to determine what kind of net shift to smart beta (dollar wise) has to occur to eliminate the premium and then determine to what extent that shift has occurred. Both very difficult numbers to arrive at. But I really wish some academic researchers would pursue this question vs. running another backtest to find some "new" factor that worked historically.
I think smart beta will be very inefficient at arbing the factors. I’d encourage people to read alpha architects work in general but also on closet indexing in particular. Smart beta might in the end be the worst of both worlds. With large AUM, it is essentially a market cap index with a tilt. So if the fund fee is 40 basis points and the fund is 80% market cap weight, you could have paid 6 bps for vanguard total stock or S&P, so effectively you paid 1.7% fees for the 20% of tilt. As those funds grow in size they just become more like the market and lose their tilts. This is an area where factor investors and market cap weighters should be able to agree.

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Re: Is Beta a distinct factor or a summation of other factors

Post by packer16 » Mon Jan 01, 2018 10:22 pm

Thanks for the replies. In terms of terminology I think the price in an efficient market is the best estimate of value. For the price to reflect this you need have a diversity of values that are independently derived. If this is the case, any other price on average is worse. There are going to be cases that the price does not equal the value (esp. in non-predicable industries). Given the price is the best on average price and you are holding many stocks, the best portfolio to own is the market portfolio. If you have a variant perspective on a specific stock & you are correct then you will be rewarded. However, as you increase the number of variant perspectives you have you have a higher probability of being wrong and the market on average being right. That is why I skeptical about factors as the returns are based upon an average of many stocks versus being right on a minority of stocks (which I think is what value investing is about). I agree folks may want different risk exposures but expecting to get a higher risk/reward tradeoff (or a more efficient portfolio) absent capitalizing on a mispricing, I think is a fantasy.

How the market incorporates these factors is interesting and I think it is worthy of study as if you can find where the market is not incorporating these factors is where the opportunity lies. The book "Pitch The Perfect Investment" has a good description of the efficiency process. I just think the more you average stocks together in an index (like SCV factor funds), the more difficult it is to outperform (have a better risk/return tradeoff or be more efficient) as you are betting the market is wrong on average amongst a group of stocks. IMO it much more realistic for the market to mispricing a small group of stocks versus a larger group. The folks at Alpha Architects have done a nice job of putting together focused factor portfolios to see if the factor framework can work in a focused fashion. The jury is out as the performance of the funds at this point are just average and given the formulaic approach the portfolio is subject to quant arbitrage that more subjective value criteria.

I think the edge you can have as a value investor is to incorporate information not found in a screen, which is what factor investors are doing. By incorporating this non-screen information, you edge becomes more sustainable versus erodable.

As to low correlated assets, I think they make sense for folks that have fixed expenditures. Many institutions have this & are constrained by this & thus want a smooth stream of payments & will sacrifice returns for this. IMO one the advantages we have individuals in our ability to have variable expenditures. This ability can built up over time as we save & developed into a habit which can be useful in the distribution phases of our lives. The ability to have variable expenditures can allow us to focus on maximizing returns with lumpy payments & thus be risk takers from those who want pay for someone to assume their lumpy payments.

I think the danger of factor investing is as one has stated that you can load up on SCV & bonds & expect to have the same expected return as TSM & bonds portfolio with more stocks. This is wrong & dangerous. I have a thread on here that tracks a Larry Portfolio assuming this is true (after Larry published his article) & the LP underperforms by a large margin the equivalent TSM/bond portfolio per the article. For example if you use a 40/60 SCV/Bond and a 60/40 TSM/Bond portfolio from 2012 to 2017, you underperform the TSM portfolio by 25% over 5 years. I am not saying the concept is not valid, just pointing a weakness you need to be aware of if you go down this path.

I am not saying factors are not useful for explaining past behavior but expecting them to act the same as history going forward given that there are little to no impediments to them being efficiently priced into prices, I think in naive & building an investment approach based upon this assumption can be dangerous to your wealth.

Packer
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Re: Is Beta a distinct factor or a summation of other factors

Post by Robert T » Tue Jan 02, 2018 7:53 am

.
Very few people hold exactly the same portfolio. All are contributing to market clearing prices. So how can the overall market be efficient, and ‘non-market’ portfolios that aggregate to the market portfolio and the associated market clearing prices be inefficient?

Why does someone choose a stock-bond portfolio that is different from the ‘market portfolio’ (i.e. 55% global stocks: 45% global bonds) – because they have a different risk tolerance than the ‘average’ investor. Why does someone choose to hold more US stocks than the 50% or so in the stock portion of the market portfolio – because their circumstances differ from the average investor. As Bill Sharpe himself puts it (my underlines) …”The global market portfolio might be a good choice for a truly international investor, who lives in hotels and on airlines, pays taxes everywhere, consumes goods from all over the world, is of average age and risk tolerance, and so on. Of course this is not likely to describe anyone in this room. But the global market portfolio is a good place for you to start, tilting each of your investment positions in a direction that makes sense, based on the differences between your characteristics and those of this fictional global investor.” IMO same is true for any tilt – including to value and small cap stocks. In addition, arguably the market portfolio also includes not just traded financial assets, but also consumer durables, real estate, and human capital. While institutional investors are a dominant share of the market – they also have their own ‘personal circumstance’ such as career risk from deviating too significantly from core benchmarks such as the S&P500.

A view that everyone should hold the market portfolio (55% stocks:45% bonds, split about evenly between US and Intl) is a bit simplistic IMO. While the attraction of the CAPM is its theoretical simplicity, the empirical record of the model is poor (as reflected above) – perhaps because of its oversimplifying assumptions.

Robert
.

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Re: Is Beta a distinct factor or a summation of other factors

Post by Valuethinker » Tue Jan 02, 2018 9:22 am

betablocker wrote:
Sun Dec 31, 2017 6:08 pm
Taylor Larimore wrote:
Sun Dec 31, 2017 4:19 pm
Big asset managers know that factors will outperform in the long term but there are of course periods of underperformance.
betablocker:

What is your source?

Thank you and Happy New Year!
Taylor
This was a key paper from 1995 on the limits to arbitrage: http://www.nber.org/papers/w5167.pdf. Often cited indirectly by Larry as well when he refers to limits to arbitrage. You can also read diy financial advisor from Wes Gray at Alpha Architect which ties the concept to particular factors or there are several blogs and white papers they’ve written on the topic.
Thank you!

That really is a key paper. It explains how we get financial bubbles even if (most) investors are rational.

I am looking at Canadian housing now (Vancouver and Toronto) and Bitcoin.

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Re: Is Beta a distinct factor or a summation of other factors

Post by betablocker » Tue Jan 02, 2018 10:08 am

packer16 wrote:
Mon Jan 01, 2018 10:22 pm
Thanks for the replies. In terms of terminology I think the price in an efficient market is the best estimate of value. For the price to reflect this you need have a diversity of values that are independently derived. If this is the case, any other price on average is worse. There are going to be cases that the price does not equal the value (esp. in non-predicable industries). Given the price is the best on average price and you are holding many stocks, the best portfolio to own is the market portfolio. If you have a variant perspective on a specific stock & you are correct then you will be rewarded. However, as you increase the number of variant perspectives you have you have a higher probability of being wrong and the market on average being right. That is why I skeptical about factors as the returns are based upon an average of many stocks versus being right on a minority of stocks (which I think is what value investing is about). I agree folks may want different risk exposures but expecting to get a higher risk/reward tradeoff (or a more efficient portfolio) absent capitalizing on a mispricing, I think is a fantasy.

How the market incorporates these factors is interesting and I think it is worthy of study as if you can find where the market is not incorporating these factors is where the opportunity lies. The book "Pitch The Perfect Investment" has a good description of the efficiency process. I just think the more you average stocks together in an index (like SCV factor funds), the more difficult it is to outperform (have a better risk/return tradeoff or be more efficient) as you are betting the market is wrong on average amongst a group of stocks. IMO it much more realistic for the market to mispricing a small group of stocks versus a larger group. The folks at Alpha Architects have done a nice job of putting together focused factor portfolios to see if the factor framework can work in a focused fashion. The jury is out as the performance of the funds at this point are just average and given the formulaic approach the portfolio is subject to quant arbitrage that more subjective value criteria.

I think the edge you can have as a value investor is to incorporate information not found in a screen, which is what factor investors are doing. By incorporating this non-screen information, you edge becomes more sustainable versus erodable.

As to low correlated assets, I think they make sense for folks that have fixed expenditures. Many institutions have this & are constrained by this & thus want a smooth stream of payments & will sacrifice returns for this. IMO one the advantages we have individuals in our ability to have variable expenditures. This ability can built up over time as we save & developed into a habit which can be useful in the distribution phases of our lives. The ability to have variable expenditures can allow us to focus on maximizing returns with lumpy payments & thus be risk takers from those who want pay for someone to assume their lumpy payments.

I think the danger of factor investing is as one has stated that you can load up on SCV & bonds & expect to have the same expected return as TSM & bonds portfolio with more stocks. This is wrong & dangerous. I have a thread on here that tracks a Larry Portfolio assuming this is true (after Larry published his article) & the LP underperforms by a large margin the equivalent TSM/bond portfolio per the article. For example if you use a 40/60 SCV/Bond and a 60/40 TSM/Bond portfolio from 2012 to 2017, you underperform the TSM portfolio by 25% over 5 years. I am not saying the concept is not valid, just pointing a weakness you need to be aware of if you go down this path.

I am not saying factors are not useful for explaining past behavior but expecting them to act the same as history going forward given that there are little to no impediments to them being efficiently priced into prices, I think in naive & building an investment approach based upon this assumption can be dangerous to your wealth.

Packer
Packer. I think it is more dangerous to have the bulk of your portfolio in one or two factors: market beta and interest rate risk. Those both underperform just like value. I like value, momentum, market, etc all together. I might underperform market for certain periods but I will most likely outperform at other times. Not sure about your points about screens. I don’t think fundamental stock pickers are capable of long term outperformance. Some that have are lucky, some were essentially just exposing themselves to factors, and some were exploiting anomalies that were arbed away. The Ren Techs of the world might be able to find alpha through sheer brains but we can’t get exposure to that and most of it is taken by the managers.

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Re: Is Beta a distinct factor or a summation of other factors

Post by triceratop » Tue Jan 02, 2018 10:09 am

packer16 wrote:
Mon Jan 01, 2018 10:22 pm
Thanks for the replies. In terms of terminology I think the price in an efficient market is the best estimate of value. For the price to reflect this you need have a diversity of values that are independently derived. If this is the case, any other price on average is worse. There are going to be cases that the price does not equal the value (esp. in non-predicable industries). Given the price is the best on average price and you are holding many stocks, the best portfolio to own is the market portfolio. If you have a variant perspective on a specific stock & you are correct then you will be rewarded. However, as you increase the number of variant perspectives you have you have a higher probability of being wrong and the market on average being right. That is why I skeptical about factors as the returns are based upon an average of many stocks versus being right on a minority of stocks (which I think is what value investing is about). I agree folks may want different risk exposures but expecting to get a higher risk/reward tradeoff (or a more efficient portfolio) absent capitalizing on a mispricing, I think is a fantasy.

How the market incorporates these factors is interesting and I think it is worthy of study as if you can find where the market is not incorporating these factors is where the opportunity lies. The book "Pitch The Perfect Investment" has a good description of the efficiency process. I just think the more you average stocks together in an index (like SCV factor funds), the more difficult it is to outperform (have a better risk/return tradeoff or be more efficient) as you are betting the market is wrong on average amongst a group of stocks. IMO it much more realistic for the market to mispricing a small group of stocks versus a larger group. The folks at Alpha Architects have done a nice job of putting together focused factor portfolios to see if the factor framework can work in a focused fashion. The jury is out as the performance of the funds at this point are just average and given the formulaic approach the portfolio is subject to quant arbitrage that more subjective value criteria.
You state that as you increase the number of variant perspectives that you increase your probability of being wrong. You state this at an individual stock level. That's certainly possible but I wonder whether it doesn't instead point to a possible contradiction in your thinking. That is, doesn't the fact that Value, Small, etc. persist as (a) factors among highly diversified funds that track that factor(s) prove the opposite? If the market has already priced them accordingly and eliminated the factor, why do factor funds which have 600+ stocks across sectors have obviously divergent behavior from the total market? Does this not point to at least a distinct source of risk, if not, as we would like, even a source of potential return.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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