Factor Investing Makes Someone Money, But Maybe Not You

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Rick Ferri
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Factor Investing Makes Someone Money, But Maybe Not You

Post by Rick Ferri » Thu Jun 21, 2018 8:14 am

Factor investing is discussed ad nauseam on this forum. Lately, it has reached the point were investors who shouldn’t do factor investing become confused to the point of believing they should or they’ll miss out on something. Let’s correct that.

Factor investing is complex and the “optimal” way to do it is always changing because there is no optimal way that can be known in advance. The idea that factor premiums can be predicted is a fallacy. The small cap premium was discovered in the 1970s... and has been dead ever since.

That being said, it’s all to common for advisers to relentlessly push complex investment strategies such as “optimal factor allocation” because it makes the adviser sound like they’re smart and that brings in business to their firm.

In truth, doing these strategies through an adviser cost more money. Even if it works the net-of-fee result to an investor isn’t any better than a total market index fund.

Even if done without an adviser the strategy is riskier and more costly than using traditional index funds. Also, it’s not easy sticking with something that isn’t working, which leads to behavioral mistakes and added cost.

What’s the right answer? If you really understand factors and are committed to a strategy for at least 25 years, then do factors. For everyone eles, buy a few low cost market-tracking index funds and fahgetaboutit.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by JohnDindex » Thu Jun 21, 2018 8:26 am

You forgot to mention that all of the stakeholders market the idea on "Nobel Prize Winning Research". I personally think that it is a good thing, it keeps the market efficient. Factor funds are rules based IMO, it is really not a new idea, just different rules that are constantly evolving.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by zwzhang » Thu Jun 21, 2018 8:31 am

Rick Ferri wrote:
Thu Jun 21, 2018 8:14 am
Factor investing is complex and the “optimal” way to do it is always changing because there is no optimal way that can be known in advance. The idea that factor premiums can be predicted is a fallacy. The small cap premium was discovered in the 1970s... and has been dead ever since.
...
Even if done without an adviser the strategy is riskier and more costly than using traditional index funds. Also, it’s not easy sticking with something that isn’t working, which leads to behavioral mistakes and added cost.
+1
"The greatest enemy of a good plan, is the dream of a perfect plan."
Just keep it simple, and stay the course.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by retiredjg » Thu Jun 21, 2018 8:35 am

Thanks Rick!

This may be the most important post of the year!

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by David Jay » Thu Jun 21, 2018 8:40 am

Rick Ferri wrote:
Thu Jun 21, 2018 8:14 am
Also, it’s not easy sticking with something that isn’t working, which leads to behavioral mistakes and added cost.
What’s the right answer? If you really understand factors and are committed to a strategy for at least 25 years, then do factors.
As I posted on your "simplicity" topic:

What is important about any "tilt" is that you believe in it enough to convince yourself to stay the course though a decade or more of underperformance.
Prediction is very difficult, especially about the future - Niels Bohr | To get the "risk premium", you really do have to take the risk - nisiprius

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by packer16 » Thu Jun 21, 2018 8:48 am

To give those how think they may be missing some returns I ran a back of the envelope comparison of an equivalent 75% equity/25% bond Vanguard Life Strategy (75% LS growth/25% LS moderate growth), a 60%/15%/25% Taylor 3-Fund Portfolio (Vanguard TSM, Vangaurd TIS & Vanguard Total Bond) & RobertT's Factor ETF portfolio (same equity/bond mix) & here are the annualized results:

5-yr 10-yr 15-yr
Vanguard LS 10.2% 5.6% 8.2%
3-Fund 11.0% 7.0% 9.0%
Robert T's ETF 8.8% 5.9% 9.7%

I really appreciate folks like Robert T that have provided real returns on factor portfolios. Note that the longer period includes in early 2000s when factor investing was not as popular as it is today. The factor portfolio had a smaller drawdown in 2008 (27% vs. 29% for 3-fund & 33% for VLS) but over the subsequent 9 years the 3-fund has caught-up and passed the factor portfolio. I know this is just one way to implement factors but I think that is where the complexity comes in vs. the simplicity of the 3-fund & Vanguard LS. Just a data point.

Packer
Last edited by packer16 on Thu Jun 21, 2018 5:00 pm, edited 2 times in total.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Taylor Larimore » Thu Jun 21, 2018 9:04 am

Rick:

Thank you for your experienced opinion (Rick is the author of 6 investment books and hundreds of articles. He co-authored a research paper on index investing that won the S&P Dow Jones Indices 3rd Annual SPIVA Award).

In September, 2016, I made this post on the subject of "Factors":
Bogleheads:

In recent years, the investment industry has begun talking about "factors" as a way to beat the market. According to this MSCI paper, there are six "factors": Value, Low size, Low volatility, High yield, Quality and Momentum (I wonder why "Low-cost" was not included). According to MSCI (which provides data for the financial industry): "these factors are grounded in academic research and have solid explanations as to why they historically have provided a premium."

I am skeptical, primarily because nearly all academic research about investing is based on past performance which experienced investors and the government warn us against.

I have also learned from experience (and professor Burton Malkiel) who wrote: "The very popularity of any investment style will sow the seeds of its own destruction." I well remember the popularity of Penny stocks, Day Trading, the "Nifty-Fifty," Dogs of the Dow, IPOs, Commodities, etc..

This 2003 post of mine, containing an article, PREDICTING THE PAST, recalls the "factors" of earlier days.

I am confident that every mutual fund manager knows about "factors" and many managers use them. Nevertheless, the majority of fund managers underperform simple broad market index funds.
Aswarth Damodaran, NYU Professor and author of 20+ finance books: "Beating the market is never easy and anyone who argues otherwise is fighting history and ignoring the evidence."
A study by Rick Ferri & Alex Benke found that an all index 3-fund market portfolio outperformed active portfolios 82.9% of the time during a 16-year period (1997-2012). That's good enough for me. It also reflects results from my Three-Fund Portfolio post.
"The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk. -- There may be better investment strategies than owning just three broad-based index funds but the number of strategies that are worse is infinite." -- Jack Bogle
"You don’t need to constantly add new asset classes or investments just because investment firms keep bringing them out. In fact, if you do, you’re more likely to end up with an unwieldy hodge-podge of investments that’s difficult to manage rather than a simpler portfolio that more efficiently balances risk and return." -- Walter Updegrave
The oldest multi-factor fund I could find is PNC Multi-Factor Small-Cap Value C (PSVCX). It's 15-year average return was 5.72%. Total Stock Market (VTSAX) 15-year average return was 7.63%.

AQR is noted for its factor funds. This 2017 study by Tom Allen and Mark Hebner found: (16 funds) have underperformed their respective benchmarks since inception and only 8 funds outperformed.
"Profitable strategies, if they exist at all, do not last for very long. As soon as they are discovered, they are acted upon by the investment community bidding up the price of the relevant assets, thus eliminating their excess return." -- Bill Bernstein in The Intelligent Asset Allocator
Wall Street has a particular fetish for inventing unnecessarily complicated ways of achieving simple goals. Most other professions, so far as I can tell, are more comfortable offering simple ways to do simple things. On Wall Street, complicated ways to do simple things have bigger payoffs — for Wall Street, that is. So complexity proliferates, and it gets encrusted with jargon to impress investors into thinking there’s something special about it. -- Jason Zweig, author and Wall Street Journal columnist
: Smart Beta Is Making This Strategist Sick

Factor Investing. What Went Wrong?

Best wishes.
Taylor

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

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Rick Ferri » Thu Jun 21, 2018 12:46 pm

All the chatter about tilting to factors today reminds me of the excitement of tilting to industry sector funds when they flourished in the 1990s.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by livesoft » Thu Jun 21, 2018 1:14 pm

Yep, we are on to the next big thing.

And so it goes.

Also don't forget:

International Investing Makes Someone Money, But Maybe Not You
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Momus » Thu Jun 21, 2018 1:25 pm

So, what to do here? Should we all dump all SCV and international/emerging market and just use total international and total stock market? Heck, dump it all for Vanguard total stock market VTSAX?

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Alexa9 » Thu Jun 21, 2018 1:28 pm

I disagree. Tilting to small value is not complicated or difficult nor does it take a CFA to understand.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by triceratop » Thu Jun 21, 2018 1:33 pm

Momus wrote:
Thu Jun 21, 2018 1:25 pm
So, what to do here? Should we all dump all SCV and international/emerging market and just use total international and total stock market? Heck, dump it all for Vanguard total stock market VTSAX?
That makes Vanguard executives money. Perhaps the only thing left to do is to buy US treasury bills and notes at auction through Treasury Direct.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Carol88888 » Thu Jun 21, 2018 1:55 pm

I am confused. Bernstein states that as soon as the factors are known they are acted upon and bid up, thus reducing their advantage. But couldn't I say the same thing about index funds? They've become so popular that people keep on buying them without regard to price they are paying for the underlying assets.

I agree that the factor funds don't make sense if they cost much more than the index funds. But then again, Vanguard is coming out with a slew of new
factor funds and I doubt that they will be expensive.

I bought VIG thinking it made sense. 1) It doesn't over lap at all with what I have already 2) it is strategy I understand 3) Past performance showed it had less of a drawn down in down market (I know - it's only past performance but what other metric do we have?)

Will it outperform? Maybe. Maybe not. But if It is something I can hold onto for the long term it probably won't do much worse than the market and my results will be better because I can stay the course.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by knpstr » Thu Jun 21, 2018 2:08 pm

Momus wrote:
Thu Jun 21, 2018 1:25 pm
So, what to do here? Should we all dump all SCV and international/emerging market and just use total international and total stock market? Heck, dump it all for Vanguard total stock market VTSAX?
I think you should do what Bogle has said. Find an allocation you're comfortable with and stay the course, ignore the noise and finally don't do something, just stand there.

I personally just hold 1 fund -- Total Stock Market. It is good enough for my goals. My "excess" or "market beating" returns are found in select real estate investments.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Rick Ferri » Thu Jun 21, 2018 2:16 pm

My goal with this post is NOT to convince anyone to avoid a factor tilt strategy; it’s to ensure people know what they’re getting into. It takes a higher cost and die-hard discipline needed to make this strategy work in the long-term.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by aspirit » Thu Jun 21, 2018 5:26 pm

I applaud your statement Rick, your having owned Portfolio-Solutions and all :happy :thumbsup

I recall trading in the sectors you speak of in the 90s.., returns now support a core concentration like TL's3 fund.

Best to both of you!
Last edited by aspirit on Sat Jun 23, 2018 8:49 pm, edited 1 time in total.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by patrick013 » Thu Jun 21, 2018 6:35 pm

I agree with Rick, a general index is a general index.
Advisors can show off certain stocks but alot cannot, and
advisors can show off certain index concentrations but as a
factor result of concept. Most of these models haven't made
it into business statistics books for non-math majors where
pragmatic use is more important but rather used in academic
research.
age in bonds, buy-and-hold, 10 year business cycle

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Fallible » Thu Jun 21, 2018 8:53 pm

Rick Ferri wrote:
Thu Jun 21, 2018 8:14 am
Factor investing is discussed ad nauseam on this forum. Lately, it has reached the point were investors who shouldn’t do factor investing become confused to the point of believing they should or they’ll miss out on something. Let’s correct that.

Factor investing is complex and the “optimal” way to do it is always changing because there is no optimal way that can be known in advance. The idea that factor premiums can be predicted is a fallacy. The small cap premium was discovered in the 1970s... and has been dead ever since.

That being said, it’s all to common for advisers to relentlessly push complex investment strategies such as “optimal factor allocation” because it makes the adviser sound like they’re smart and that brings in business to their firm.

In truth, doing these strategies through an adviser cost more money. Even if it works the net-of-fee result to an investor isn’t any better than a total market index fund.

Even if done without an adviser the strategy is riskier and more costly than using traditional index funds. Also, it’s not easy sticking with something that isn’t working, which leads to behavioral mistakes and added cost.

What’s the right answer? If you really understand factors and are committed to a strategy for at least 25 years, then do factors. For everyone eles, buy a few low cost market-tracking index funds and fahgetaboutit.
Behavioral errors can be in play even before an investor actually commits to more complex investing. A common error we all have to watch out for is overconfidence, which can lead to other errors such as confirmation bias. Investment decisions are based on how well we understand the investment, but also on how well we understand ourselves.

Thanks for posting, Rick, and thanks to Taylor for adding background.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Random Walker » Thu Jun 21, 2018 9:26 pm

Many people seem to look at factors only as a potential source of increased return. I think the best use of them is to diversify sources of return. Tilting to the factors and increasing safe bond allocation should improve portfolio efficiency for any given expected return: diversify sources of uncorrelated return, decrease SD for same expected return, decrease maximal drawdown, lessen volatility drag. Diversifying across the factors pretty much definitionally means that some will always be performing well and others will be underperforming. I think knowledge that he is as diversified across sources of return as reasonably doable should provide the investor with the fortitude to stick to the plan. All of this comes of course at increased cost. The biggest potential cost of all is likely a behavioral error. So the best plan for any individual is the one that maximizes the likelihood that he stay the course.

Dave

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Robert T » Fri Jun 22, 2018 5:07 am

.
From this Fama-French 1993 article : Risk factors in equities = exposure to market, value, and size; in bonds = exposure to term and default risk.

“Factor investing” is often discussed as if exposure to the market is not a risk factor, while it is the largest of those in the Fama-French article. Everyone who holds an equity market portfolio does “factor investing”, having exposure to a single risk factor. So factor investing can be very simple, but can also be made more complex.

Just as it is hard to determine, ex-ante, the optimal stock-bond portfolio, the same is true for other factors. And sticking with a single factor can be just as hard as sticking with a multifactor portfolio – just ask anyone holding an equity market portfolio at the end of 2008.

Advisor fees cut into any realized factor premiums. After advisor fees, a person holding a market portfolio will received less that a market return, and a person holding a portfolio with additional tilts to other risk factors will receive less than the portfolio exposure share of any realized premiums to these other factors. Basic math. For a stock-bond portfolio, with the stock portion tilted moderately to small-cap and value stocks, the advisor fee can equate to all the additional (expected and realized) returns from the tilt to these two factors.

There will always be debates on value vs growth etc. They are not new. They are the same/similar debates 15+ years ago when I started, and they will likely be the same debates in 15 years time

Do your own research, make your own allocation decisions, and stick with it. The last part is not easy but important. Even some advisors seem to have a hard time sticking with allocations over the long-term.

Obviously no guarantees.

Robert
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by longinvest » Fri Jun 22, 2018 6:17 am

Robert T wrote:
Fri Jun 22, 2018 5:07 am
“Factor investing” is often discussed as if exposure to the market is not a risk factor, while it is the largest of those in the Fama-French article. Everyone who holds an equity market portfolio does “factor investing”, having exposure to a single risk factor. So factor investing can be very simple, but can also be made more complex.
I'll let our mentor Jack Bogle explain the specificity of the market portfolio:
Finally, Taylor read my first book, Bogle on Mutual Funds, and was persuaded by my unassailable Cost Matters Hypothesis: The gross return of the market, minus the costs of investing, equals net return to investors. If active investors in aggregate own the market, which they do, as a group they receive the market’s return minus the high costs of active investing. Index investors also own the market, but at rock-bottom cost. So the average actively-managed portfolio will, of necessity, underperform the average indexed portfolio. Investing in index funds is the only way to guarantee that you’ll receive your fair share of the market’s return.

-- John C Bogle, in the Foreword of Taylor Larimore's The Bogleheads' Guide to the Three-Fund Portfolio (2018)
Let me repeat it: Investing in index funds is the only way to guarantee that you’ll receive your fair share of the market’s return.

The other "factors" don't share this property.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by jeffyscott » Fri Jun 22, 2018 7:21 am

Robert T wrote:
Fri Jun 22, 2018 5:07 am
“Factor investing” is often discussed as if exposure to the market is not a risk factor, while it is the largest of those in the Fama-French article. Everyone who holds an equity market portfolio does “factor investing”, having exposure to a single risk factor. So factor investing can be very simple, but can also be made more complex.

Just as it is hard to determine, ex-ante, the optimal stock-bond portfolio, the same is true for other factors. And sticking with a single factor can be just as hard as sticking with a multifactor portfolio – just ask anyone holding an equity market portfolio at the end of 2008.
I think maybe the period after the 2000 peak might be a better example? When the large cap growth bubble bust while value and small caught up, seems like sticking with a total market approach would've been harder than a portfolio tilted to small and value?
press on, regardless - John C. Bogle

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by matjen » Fri Jun 22, 2018 7:22 am

Robert T wrote:
Fri Jun 22, 2018 5:07 am
Just as it is hard to determine, ex-ante, the optimal stock-bond portfolio, the same is true for other factors. And sticking with a single factor can be just as hard as sticking with a multifactor portfolio – just ask anyone holding an equity market portfolio at the end of 2008.
Per usual, Robert T. for the win. This quoted part above cannot be stressed enough. The Three-Fund folks are so enamored with their own reasoning that they miss the forest for the trees. Over and over and over. When the rubber meets the road in a bear market I don't think the person who decided to mix in a typical SCV tilt to their portfolio by adding between 0-3 extra funds is going to somehow lose faith because the equity side of their portfolio "may" drawdown 51% compared to say 49% for a pure market cap exposure. It's the total exposure to equity beta for both portfolios that the typical person will have an issue with. Owning a market cap three fund portfolio will not change that reaction/uncomfortableness. It just won't.

I quickly put a few portfolios together on Portfolio Visualizer and there wasn't really even a drawdown difference which surprised me. 1/2002 - 5/2018
https://www.portfoliovisualizer.com/bac ... tion7_3=35

Portfolio 1
35% Total US
35% Total Internationl
30% Total Bond

Portfolio 2 - Typical SCV Tilt (Similar to something Rick used to suggest it seems to me)
20% Total US
15% US SCV
35% Total International
30% Total Bond

Portfolio 3 - Swedroe Tilt
35% US SCV
35% International SCV
30% Total Bond

Image
Last edited by matjen on Fri Jun 22, 2018 7:39 am, edited 1 time in total.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by UpperNwGuy » Fri Jun 22, 2018 7:33 am

Why did you pick 2002 as your starting point?

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by matjen » Fri Jun 22, 2018 7:37 am

UpperNwGuy wrote:
Fri Jun 22, 2018 7:33 am
Why did you pick 2002 as your starting point?
Was the oldest starting point for the funds I selected. I'm guessing that if I went back a year more the SCV parts would have done much better because of the rebound off the tech bubble.
Note: The time period was automatically adjusted based on the available data (Jul 2001 - May 2018) for the selected asset: Vanguard Total Stock Market ETF (VTI)
Really the most important thing to me though was the drawdown and worst year figures.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by jeffyscott » Fri Jun 22, 2018 7:51 am

packer16 wrote:
Thu Jun 21, 2018 8:48 am
To give those how think they may be missing some returns I ran a back of the envelope comparison of an equivalent 75% equity/25% bond Vanguard Life Strategy (75% LS growth/25% LS moderate growth), a 60%/15%/25% Taylor 3-Fund Portfolio (Vanguard TSM, Vangaurd TIS & Vanguard Total Bond) & RobertT's Factor ETF portfolio (same equity/bond mix) & here are the annualized results:

5-yr 10-yr 15-yr
Vanguard LS 10.2% 5.6% 8.2%
3-Fund 11.0% 7.0% 9.0%
Robert T's ETF 8.8% 5.9% 9.7%

I really appreciate folks like Robert T that have provided real returns on factor portfolios. Note that the longer period includes in early 2000s when factor investing was not as popular as it is today. The factor portfolio had a smaller drawdown in 2008 (27% vs. 29% for 3-fund & 33% for VLS) but over the subsequent 9 years the 3-fund has caught-up and passed the factor portfolio. I know this is just one way to implement factors but I think that is where the complexity comes in vs. the simplicity of the 3-fund & Vanguard LS. Just a data point.

Packer
You have Robert T at 9.7% for 15 years vs. 9.0% and 8.2%, so saying "the 3-fund has caught-up and passed the factor portfolio" is incorrect. You can say the 3 fund has done better more recently. But it's not "caught up" just yet.

I don't know what Robert's international allocation is, but that seems like it would be the "factor" that matters over the past 5 and 10 years. The 10 year returns of small cap value and total stock are fairly close and at 10%+ over the past 10 years (with SCV in the lead) but international has returned only 2.65% based on Total International.
press on, regardless - John C. Bogle

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Random Walker » Fri Jun 22, 2018 8:13 am

matjen wrote:
Fri Jun 22, 2018 7:22 am
Robert T wrote:
Fri Jun 22, 2018 5:07 am
Just as it is hard to determine, ex-ante, the optimal stock-bond portfolio, the same is true for other factors. And sticking with a single factor can be just as hard as sticking with a multifactor portfolio – just ask anyone holding an equity market portfolio at the end of 2008.
Per usual, Robert T. for the win.
I would take it a step further. There are about 4-6 factors that explain about 95% of the difference between portfolio returns. When one diversifies across them, he can have the confidence that there is not much else he can do to have an excellent plan. This confidence that the investor is highly diversified across the factors can provide the strength to stick to the plan. If one has all there investment in a single factor, market beta, might they be more likely to search out other sources of return when that single factor underperforms? I don’t know the answer, but how disciplined were home country biased Japan TSM investors the last 40 years?

Dave

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by oldcomputerguy » Fri Jun 22, 2018 8:38 am

Carol88888 wrote:
Thu Jun 21, 2018 1:55 pm
I am confused. Bernstein states that as soon as the factors are known they are acted upon and bid up, thus reducing their advantage. But couldn't I say the same thing about index funds? They've become so popular that people keep on buying them without regard to price they are paying for the underlying assets.
The price per share of index mutual funds does not get "bid up". It's a calculation based on the closing prices of the underlying assets. (Of course the same cannot be said for ETFs.)
It’s taken me a lot of years, but I’ve come around to this: If you’re dumb, surround yourself with smart people. And if you’re smart, surround yourself with smart people who disagree with you.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by rkhusky » Fri Jun 22, 2018 8:46 am

Random Walker wrote:
Thu Jun 21, 2018 9:26 pm
Many people seem to look at factors only as a potential source of increased return. I think the best use of them is to diversify sources of return. Tilting to the factors and increasing safe bond allocation should improve portfolio efficiency for any given expected return: diversify sources of uncorrelated return, decrease SD for same expected return, decrease maximal drawdown, lessen volatility drag. Diversifying across the factors pretty much definitionally means that some will always be performing well and others will be underperforming. I think knowledge that he is as diversified across sources of return as reasonably doable should provide the investor with the fortitude to stick to the plan. All of this comes of course at increased cost. The biggest potential cost of all is likely a behavioral error. So the best plan for any individual is the one that maximizes the likelihood that he stay the course.

Dave
Factors are only sources of return within the constructs of the Fama-French long-short model. They are not real sources of return, which remain the goods and services that companies provide. Factor investing does not provide increased diversification of real sources of return, just the opposite. Factor investing decreases diversification of real return by investing in only a small subset of companies. Again, factors are simply a mathematical construct.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by indexonlyplease » Fri Jun 22, 2018 8:56 am

matjen wrote:
Fri Jun 22, 2018 7:22 am
Robert T wrote:
Fri Jun 22, 2018 5:07 am
Just as it is hard to determine, ex-ante, the optimal stock-bond portfolio, the same is true for other factors. And sticking with a single factor can be just as hard as sticking with a multifactor portfolio – just ask anyone holding an equity market portfolio at the end of 2008.
Per usual, Robert T. for the win. This quoted part above cannot be stressed enough. The Three-Fund folks are so enamored with their own reasoning that they miss the forest for the trees. Over and over and over. When the rubber meets the road in a bear market I don't think the person who decided to mix in a typical SCV tilt to their portfolio by adding between 0-3 extra funds is going to somehow lose faith because the equity side of their portfolio "may" drawdown 51% compared to say 49% for a pure market cap exposure. It's the total exposure to equity beta for both portfolios that the typical person will have an issue with. Owning a market cap three fund portfolio will not change that reaction/uncomfortableness. It just won't.

I quickly put a few portfolios together on Portfolio Visualizer and there wasn't really even a drawdown difference which surprised me. 1/2002 - 5/2018
https://www.portfoliovisualizer.com/bac ... tion7_3=35

Portfolio 1
35% Total US
35% Total Internationl
30% Total Bond

Portfolio 2 - Typical SCV Tilt (Similar to something Rick used to suggest it seems to me)
20% Total US
15% US SCV
35% Total International
30% Total Bond

Portfolio 3 - Swedroe Tilt
35% US SCV
35% International SCV
30% Total Bond

Image
Question: why only a one or two tilts. Is factor investing when someone invest in every asset class and size of class? If you put almost equal percent into each area would that be factor investing?

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Random Walker » Fri Jun 22, 2018 9:57 am

rkhusky wrote:
Fri Jun 22, 2018 8:46 am
Random Walker wrote:
Thu Jun 21, 2018 9:26 pm
Many people seem to look at factors only as a potential source of increased return. I think the best use of them is to diversify sources of return. Tilting to the factors and increasing safe bond allocation should improve portfolio efficiency for any given expected return: diversify sources of uncorrelated return, decrease SD for same expected return, decrease maximal drawdown, lessen volatility drag. Diversifying across the factors pretty much definitionally means that some will always be performing well and others will be underperforming. I think knowledge that he is as diversified across sources of return as reasonably doable should provide the investor with the fortitude to stick to the plan. All of this comes of course at increased cost. The biggest potential cost of all is likely a behavioral error. So the best plan for any individual is the one that maximizes the likelihood that he stay the course.

Dave
Factors are only sources of return within the constructs of the Fama-French long-short model. They are not real sources of return, which remain the goods and services that companies provide. Factor investing does not provide increased diversification of real sources of return, just the opposite. Factor investing decreases diversification of real return by investing in only a small subset of companies. Again, factors are simply a mathematical construct.
Point taken. I think the question arises “Are we investing in businesses or in the stocks of businesses?” We invest indirectly through stocks, and these are the factors shown to drive the behavior of the stocks. Small and value I believe do appear to be real sources of return. They are risks. Moreover the math you refer to indicates that they represent unique independent risks from market beta.

Dave

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by matjen » Fri Jun 22, 2018 10:09 am

indexonlyplease wrote:
Fri Jun 22, 2018 8:56 am

Question: why only a one or two tilts. Is factor investing when someone invest in every asset class and size of class? If you put almost equal percent into each area would that be factor investing?
As a starting point I would suggest this excellent overview on factor investing from Vanguard.
https://personal.vanguard.com/pdf/ISGFB ... Online.pdf

Having said that, on this board (and I think in retail investing generally), the (equity side) factors that people have tried to incorporate over the last 15 years have been market, value, size and more recently momentum. Small cap value has really been the one that was most accessible and accessible without paying for DFA or AQR, etc.
Last edited by matjen on Fri Jun 22, 2018 10:28 am, edited 1 time in total.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by zaboomafoozarg » Fri Jun 22, 2018 10:19 am

I have using a 30% tilt to SCV and REITs since 2012. Based on my calculations, this tilt hasn't really helped or hurt. My CAGR and volatility have both been about 0.05% less than a 3-fund, and I've lost about $500 total by tilting.

Honestly, the only real reason I'm tilting is the fear of missing out.
Last edited by zaboomafoozarg on Sun Jun 24, 2018 9:36 am, edited 1 time in total.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by kagantx » Fri Jun 22, 2018 10:22 am

I don't understand why people think factor investing is so difficult, given that you don't pay much for the exposure anymore. Just buy a fund like VFMF if you believe in factors. Assuming that factors don't outperform at all, you lose 4.3% of your return over a 30 year horizon assuming a 7% average nominal return (expense ratio of 0.18% vs. 0.03%). That's bad but not a disaster. A 1% expense ratio loses you 32% of your compounded investments. That's a disaster.

I would agree that paying 1% expense ratios is not worth it to gain factor exposure. But that has nothing to do with factors - it's just a matter of costs. There are plenty of active managers and hedge funds I might invest with if they charged 0.05% expense ratios, given that active managers generally outperform the market before costs by taking advantage of amateur traders' mistakes.

It's possible for a new investing idea to justify an extra 0.1% in expenses. It's impossible for it to justify an extra 1%. Let's keep a focus on costs, and not repeat efficient market dogma.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Lastrun » Fri Jun 22, 2018 12:06 pm

Random Walker wrote:
Fri Jun 22, 2018 8:13 am
I would take it a step further. There are about 4-6 factors that explain about 95% of the difference between portfolio returns. When one diversifies across them, he can have the confidence that there is not much else he can do to have an excellent plan. This confidence that the investor is highly diversified across the factors can provide the strength to stick to the plan. If one has all there investment in a single factor, market beta, might they be more likely to search out other sources of return when that single factor underperforms? I don’t know the answer, but how disciplined were home country biased Japan TSM investors the last 40 years?

Dave
Help me with an issue I have. Assume for purposes of discussion that 70% of expected returns are from market, 20% from small and value, 5 % from momentum etc. and the remaining 5% from the 396 other found factors.

Why would one tilt 70% (see the Larry tilt above) into SCV when it accounts for 20% of expected (not backtested) returns? I am not defending the market factor but it does account for a significant portion of expected returns, and it confuses me when factor proponents are critical of 3 funders for being limited to the market factor when it appears what they are suggesting (with posts above and below) is to take a 100% allocation into the market factor at 70% expected returns, and instead place it into SCV which accounts for only 20% of expected returns.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Jiu Jitsu Fighter » Fri Jun 22, 2018 12:29 pm

Lastrun wrote:
Fri Jun 22, 2018 12:06 pm
Random Walker wrote:
Fri Jun 22, 2018 8:13 am
I would take it a step further. There are about 4-6 factors that explain about 95% of the difference between portfolio returns. When one diversifies across them, he can have the confidence that there is not much else he can do to have an excellent plan. This confidence that the investor is highly diversified across the factors can provide the strength to stick to the plan. If one has all there investment in a single factor, market beta, might they be more likely to search out other sources of return when that single factor underperforms? I don’t know the answer, but how disciplined were home country biased Japan TSM investors the last 40 years?

Dave
Help me with an issue I have. Assume for purposes of discussion that 70% of expected returns are from market, 20% from small and value, 5 % from momentum etc. and the remaining 5% from the 396 other found factors.

Why would one tilt 70% (see the Larry tilt above) into SCV when it accounts for 20% of expected (not backtested) returns? I am not defending the market factor but it does account for a significant portion of expected returns, and it confuses me when factor proponents are critical of 3 funders for being limited to the market factor when it appears what they are suggesting (with posts above and below) is to take a 100% allocation into the market factor at 70% expected returns, and instead place it into SCV which accounts for only 20% of expected returns.
TSM = beta
SCV = beta + small premium + value premium

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Random Walker » Fri Jun 22, 2018 12:33 pm

Last run,
Hope I can help you. Every equity fund is exposed to factors. A TSM fund is fully exposed to the market factor and has no net exposure to size and value. So it’s loading on factors is described as market = 1, size =0, value=0. Where I think you may be confused is that a small value fund will have loadings perhaps like this: market=1, size=0.3, value=0.3. So a small value fund has full exposure to the market factor just like TSM does. Additionally it has exposure to two other factors, so in that respect it is more diversified across factors. In general, all the equity funds, no matter how highly torqued and tilted, will have lots of exposure to the market factor too, just like TSM. Perhaps you’ve read the argument that an investor should use the tilted funds that have the deepest factor exposure. The reason for this is that all our equity funds already have plenty of the market factor in them, and we are trying to diversify away from it more evenly across all the factors. So even if one concentrates their equity holdings in the tiny small value corner of the market, they still have a lot of exposure to the market factor.

Dave

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Random Walker » Fri Jun 22, 2018 12:35 pm

Ha :-) Jiu Jitsu Fighter said same thing as me in about 200 less words! Talk about efficiency.

Dave

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by cfs » Fri Jun 22, 2018 12:48 pm

Quick stop here after my LUng Distance Workout, just to say "thank you Mister Rick" for this conversation. Now back to watching the World Cup, y gracias por leer / cfs
~ Member of the Active Retired Force since 2014 ~

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by FIREchief » Fri Jun 22, 2018 1:14 pm

Rick Ferri wrote:
Thu Jun 21, 2018 8:14 am
Factor investing is complex and the “optimal” way to do it is always changing because there is no optimal way that can be known in advance. The idea that factor premiums can be predicted is a fallacy. The small cap premium was discovered in the 1970s... and has been dead ever since.

That being said, it’s all to common for advisers to relentlessly push complex investment strategies such as “optimal factor allocation” because it makes the adviser sound like they’re smart and that brings in business to their firm.
Outstanding post Rick. Thanks!! I think the bolded text above captures the root cause for all of this noise.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by Lastrun » Fri Jun 22, 2018 1:15 pm

Random Walker wrote:
Fri Jun 22, 2018 12:35 pm
Ha :-) Jiu Jitsu Fighter said same thing as me in about 200 less words! Talk about efficiency.

Dave
Thanks to both, very very helpful to something that has been stuck in my head for a while that I could not resolve.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by FIREchief » Fri Jun 22, 2018 1:16 pm

JohnDindex wrote:
Thu Jun 21, 2018 8:26 am
You forgot to mention that all of the stakeholders market the idea on "Nobel Prize Winning Research".
Bingo!! Funny how those words cause some to run towards the salesperson and others of us to run in the opposite direction.
I am not a lawyer, accountant or financial advisor. Any advice or suggestions that I may provide shall be considered for entertainment purposes only.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by packer16 » Fri Jun 22, 2018 1:22 pm

One key point here & why the controversies exists is the differences between past and expected returns. Everyone can agree that factors explain 90%+ of past returns but not necessarily expected or future returns. The same is true for correlation. Factors have not been correlated with stocks in the past in a favorable way but the future is unkonwn & they may become more correlated in the future. The main point here is the market is not a machine or natural process where many of the tools used to derive factors are used to determine if relationships exist. With a machine or natural process you can be pretty much assured that if you find a relationship it will hold 99%+ of the time in markets not so much because the factors & the magnitude of those factors driving returns are constantly changing. What has been observed are the factors and their weights in the past.

That IMO is why actual "factor" portfolio returns (after fees) versus low cost portfolios such as the 3 fund portfolio is so important. The timeframe those returns are also important. Over time the factor portfolios have become more popular & given this you would expect lower returns as "factor" stocks are more in demand than if these factor strategies were not invested in.

IMO the 3 fund portfolio is the default & anything else you invest in should be compared to this (with applicable bond/stock mix) to see if it is superior. Now there are more dimensions than return that are important to folks. So for some drawdown is important so this also has to be examined. I would like to hear actual experience of folks & when they started that hold factor tilts. RobertT has provided his returns which provide a test & show the factor portfolio outperformed for the 15 year time period but not the 5 & 10-year periods. It sounds like zaboomafoozarg had similar experience to when he started around 6 years ago.

IMO the tech boom & bust influenced value factor returns alot. It appears if you exclude that period then the return to the value factor is much closer or even lover that the market return. So IMO the question for today is are we in a tech "bubble" where these excess value returns can expect to be realized. IMO we are not so I would expect value to be equal to or less than market until such as event happens. Just my 2 cents.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by FIREchief » Fri Jun 22, 2018 2:52 pm

Well stated Packer. I can't imagine anybody could argue any of your points (that's a joke :twisted: ).
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by matjen » Fri Jun 22, 2018 2:58 pm

FIREchief wrote:
Fri Jun 22, 2018 2:52 pm
Well stated Packer. I can't imagine anybody could argue any of your points (that's a joke :twisted: ).
Let me be the first!

Packer has said this in both his posts on this thread and just assumed it to be true. It really isn’t.
Over time the factor portfolios have become more popular & given this you would expect lower returns as "factor" stocks are more in demand than if these factor strategies were not invested in.
Asness has written a bunch on this. Value in particular is not historically expensive. Just because you read more about smart beta more doesn’t mean the vast, vast majority of people who don’t hang out on this forum know about it. Additionally, so much money is going to indexing and that money partially is coming from active strategies. Those pickers probably used some factor screens, etc. but charged too much for it. My guess as to why some popular factors aren’t rich.

Also, stocks move in and out of being a “factor” stock it seems to me. It’s not just a constant group of stocks that is now expensive.
Here is an Asness blog post on the topic. There have been more.

https://www.aqr.com/Insights/Perspectiv ... s-About-It
As of now, in broad generality (we expect to write more on this soon) we do see spreads on many factors somewhat tighter than they have been in the past, but not shockingly so (in fact, in our main example today's spread is almost exactly at the historical median). Moreover, they are considerably less tight than are the valuations of long-only stock and bond markets versus their own historical valuations. 15
In other words, if value spreads on these known factors are somewhat tight versus history, they are not, in our view, nearly as tight as traditional markets are expensive versus their own history.
Last edited by matjen on Fri Jun 22, 2018 3:44 pm, edited 1 time in total.
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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by packer16 » Fri Jun 22, 2018 3:14 pm

How do you know value is not expensive? Typically it is by comparing the P/BV or P/Earnings metric of groups of stocks (value vs. growth for instance). The only problem with this it assumes the quality (including expected growth) of each group remains constant over time. I am not sure this is true & no one has been able to show me data that this is case, they blindly use a metric that is based upon an assumption that is not tested. If the actual growth of the value groups of stocks is less than it has been historically & growth higher than it has been historically you would expect the discount to grow. You would expect in a more efficient market over time that the quality & earnings growth of the value stocks to decline and growth stocks to increase so you should expect the value group to sell at a larger discount than the growth group. I have only observed that value screens over the years have generated more operationally & financially challenged firms than in the past and thus they should trade for less than the historical average of the differences between value & growth stocks. To quantify this you can use the Graham formula:

P/E = 8.5 + 2g

So for every 1% reduction in growth you should expect your multiple to decline by 2. So for small changes in growth you can see large changes in the normalized difference between the growth and value stocks.

As to stock pickers using factors, it is not true. The processes of selecting stocks is fundamentally different. Factors do not take into account fundamentals they just use what has driven stock prices in the past for selection versus understanding businesses (which is what most stock pickers do) and what drives the value in the future. Just my 2 cents.


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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by rkhusky » Fri Jun 22, 2018 4:10 pm

FIREchief wrote:
Fri Jun 22, 2018 1:16 pm
JohnDindex wrote:
Thu Jun 21, 2018 8:26 am
You forgot to mention that all of the stakeholders market the idea on "Nobel Prize Winning Research".
Bingo!! Funny how those words cause some to run towards the salesperson and others of us to run in the opposite direction.
Plus, the Nobel winning research involved explaining past portfolio returns in terms of a few free parameters. It was not a method for beating the market.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by rkhusky » Fri Jun 22, 2018 4:21 pm

Random Walker wrote:
Fri Jun 22, 2018 9:57 am
I think the question arises “Are we investing in businesses or in the stocks of businesses?” We invest indirectly through stocks, and these are the factors shown to drive the behavior of the stocks.
It is true that we invest in stocks, but stock prices are driven by the goods and services that companies provide and the expectation of the market that a particular company's goods and services will provide a profit, as well as outperforming their competitors and thus, increasing profits. I don't think market makers care whether a stock is classified as small or value.
Random Walker wrote:
Fri Jun 22, 2018 9:57 am
Small and value I believe do appear to be real sources of return. They are risks.
Within Fama/French, they are components of return, which can be both positive or negative. Using language such as "source of return" may lead some to only think of positive return. The Fama/French formulation does not address outperforming the market, it is concerned with describing past portfolio returns in terms of a few free parameters and some basis vectors.
Random Walker wrote:
Fri Jun 22, 2018 9:57 am
Moreover the math you refer to indicates that they represent unique independent risks from market beta.
The long-short formulation in FF is relatively independent. Long small or long value by itself is not independent.

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by columbia » Fri Jun 22, 2018 4:59 pm

I “get” the idea using the momentum factor, but have any real world funds been around long enough to demonstrate that it works (or doesn’t)?

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Re: Factor Investing Makes Someone Money, But Maybe Not You

Post by jeffyscott » Fri Jun 22, 2018 5:27 pm

packer16 wrote:
Fri Jun 22, 2018 3:14 pm
As to stock pickers using factors, it is not true. The processes of selecting stocks is fundamentally different. Factors do not take into account fundamentals they just use what has driven stock prices in the past for selection versus understanding businesses (which is what most stock pickers do) and what drives the value in the future.
There are managed value funds, small cap funds, small cap value funds. They may or may not be using "factor screens" in the way a passive fund would, but they are buying the same stocks. The end result is the same: an active fund tilted toward one factor or another.

If lots of people are selling managed small cap and value funds and buying total market index funds, that sure seems like it could lower the price of small cap value stocks due to reduced demand.
press on, regardless - John C. Bogle

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