The Bottom Line on Factor Investing

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acegolfer
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

Random Walker wrote: Thu Apr 30, 2020 10:29 am Wouldn’t the recent relatively bad performance represent greater risk? And shouldn’t greater risk be associated with increased expected return?

Dave
To answer your 2nd question, not always. Only the systematic risk should be compensated. Are you suggesting that the recent relatively bad performance is a systematic risk? Can you elaborate?
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simplesauce
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Re: The Bottom Line on Factor Investing

Post by simplesauce »

Taylor Larimore wrote: Thu Apr 30, 2020 11:53 am
Dave wrote: shouldn’t greater risk be associated with increased expected return?
Dave:

Many years ago when we were invested with Merrill Lynch, our "Advisor" recommended the Merrill Lynch Phenix Fund which we purchased. His primary selling point was that this fund invested in risky companies that were expected to become winners. He was wrong and the Phenix Fund folded along with most of our investment.

I also remember when the risky Vanguard Gold Fund had the BEST 10-year performance of all Vanguard Funds. During the next 10 years it had the WORST performance of all Vanguard funds. It subsequently changed its name to the "Gold and Precious Metals Fund."

It is very dangerous to assume that greater risk will result in increased expected return. There is no better example than the current dismal performance of risky Small Cap Value Funds.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "Investors seem hell-bent on carrying out the search for winning funds of the future, no matter how futile the search has proven to be."
Thank you Taylor!
Random Walker
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

acegolfer wrote: Thu Apr 30, 2020 12:01 pm
Random Walker wrote: Thu Apr 30, 2020 10:29 am Wouldn’t the recent relatively bad performance represent greater risk? And shouldn’t greater risk be associated with increased expected return?

Dave
To answer your 2nd question, not always. Only the systematic risk should be compensated. Are you suggesting that the recent relatively bad performance is a systematic risk? Can you elaborate?
Yes I’m referring to systematic risk: risk that can’t be diversified away. Yes I think the performance of the SV asset class as a whole represents systematic risks represented by some combination of market factor, size factor, value factor.

Dave
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Re: The Bottom Line on Factor Investing

Post by abuss368 »

Taylor Larimore wrote: Thu Apr 30, 2020 11:53 am
Dave wrote: shouldn’t greater risk be associated with increased expected return?
Dave:

Many years ago when we were invested with Merrill Lynch, our "Advisor" recommended the Merrill Lynch Phenix Fund which we purchased. His primary selling point was that this fund invested in risky companies that were expected to become winners. He was wrong and the Phenix Fund folded along with most of our investment.

I also remember when the risky Vanguard Gold Fund had the BEST 10-year performance of all Vanguard Funds. During the next 10 years it had the WORST performance of all Vanguard funds. It subsequently changed its name to the "Gold and Precious Metals Fund."

It is very dangerous to assume that greater risk will result in increased expected return. There is no better example than the current dismal performance of risky Small Cap Value Funds.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "Investors seem hell-bent on carrying out the search for winning funds of the future, no matter how futile the search has proven to be."
Hi Taylor -

We too were placed in a Merrill Lynch fund that had good performance for a couple of years. The fund eventually folded into another Merrill Lynch fund.

I learned to own the market with low cost index funds.
John C. Bogle: “Simplicity is the master key to financial success."
acegolfer
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

Random Walker wrote: Thu Apr 30, 2020 12:51 pm
acegolfer wrote: Thu Apr 30, 2020 12:01 pm
Random Walker wrote: Thu Apr 30, 2020 10:29 am Wouldn’t the recent relatively bad performance represent greater risk? And shouldn’t greater risk be associated with increased expected return?

Dave
To answer your 2nd question, not always. Only the systematic risk should be compensated. Are you suggesting that the recent relatively bad performance is a systematic risk? Can you elaborate?
Yes I’m referring to systematic risk: risk that can’t be diversified away. Yes I think the performance of the SV asset class as a whole represents systematic risks represented by some combination of market factor, size factor, value factor.

Dave
I asked why SCV's recent bad performance is considered as a systematic risk. You answered because of risk factors. Isn't that a tautology?
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vineviz
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Re: The Bottom Line on Factor Investing

Post by vineviz »

acegolfer wrote: Thu Apr 30, 2020 1:51 pm I asked why SCV's recent bad performance is considered as a systematic risk. You answered because of risk factors. Isn't that a tautology?
I think you misunderstood the original claim.

Underperformance can be evidence of a systematic risk: underperformance itself is not the systematic risk.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
Triple digit golfer
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Re: The Bottom Line on Factor Investing

Post by Triple digit golfer »

I have a question that maybe someone can help me with.

We all know that total market funds cover something like 95-99% of the stock market (I'm just assuming; maybe it's 99%+) and that S&P 500 index funds cover around 80%.

Does anybody know what percentage of the market is covered by VBR or VIOV or where to even find that information? Just curious.
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

vineviz wrote: Thu Apr 30, 2020 2:16 pm Underperformance can be evidence of a systematic risk: underperformance itself is not the systematic risk.
agreed.
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Re: The Bottom Line on Factor Investing

Post by grabiner »

Triple digit golfer wrote: Thu Apr 30, 2020 2:20 pm I have a question that maybe someone can help me with.

We all know that total market funds cover something like 95-99% of the stock market (I'm just assuming; maybe it's 99%+) and that S&P 500 index funds cover around 80%.

Does anybody know what percentage of the market is covered by VBR or VIOV or where to even find that information? Just curious.
You need to look at the index definitions. For the CRSP indexes Vanguard uses, go to CRSP Index Methodology Guide. It says that the small-cap index is from 85% to 98% of the market; the value index VBR is half of that.

The S&P indexes don't cover the whole market segment, but they are intended to be representative of the market. The S&P 600 tracks approximately the bottom 10% of the market (but holds only about 1/3 of those stocks; the Russell 2000 tracks the same market segment); again, the value index VIOV is half of that.
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Re: The Bottom Line on Factor Investing

Post by Triple digit golfer »

grabiner wrote: Thu Apr 30, 2020 3:20 pm
Triple digit golfer wrote: Thu Apr 30, 2020 2:20 pm I have a question that maybe someone can help me with.

We all know that total market funds cover something like 95-99% of the stock market (I'm just assuming; maybe it's 99%+) and that S&P 500 index funds cover around 80%.

Does anybody know what percentage of the market is covered by VBR or VIOV or where to even find that information? Just curious.
You need to look at the index definitions. For the CRSP indexes Vanguard uses, go to CRSP Index Methodology Guide. It says that the small-cap index is from 85% to 98% of the market; the value index VBR is half of that.

The S&P indexes don't cover the whole market segment, but they are intended to be representative of the market. The S&P 600 tracks approximately the bottom 10% of the market (but holds only about 1/3 of those stocks; the Russell 2000 tracks the same market segment); again, the value index VIOV is half of that.
Thank you. Makes sense. So VBR is around 7% of the market and VIOV is around 5%, but holds only 1/3 of the stocks in that 5%.
aristotle'sfootprint
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Re: The Bottom Line on Factor Investing

Post by aristotle'sfootprint »

vineviz wrote: Thu Apr 30, 2020 2:16 pm
acegolfer wrote: Thu Apr 30, 2020 1:51 pm I asked why SCV's recent bad performance is considered as a systematic risk. You answered because of risk factors. Isn't that a tautology?
I think you misunderstood the original claim.

Underperformance can be evidence of a systematic risk: underperformance itself is not the systematic risk.
I hope you all don't mind if I ask a naive question that's maybe a bit prior to this issue. Suppose a risk story for the size and value premiums is true. Is there an intuitive, non-technical way to understand why the existence of unique sources of systematic risk should be associated with *higher* expected returns? I'm trying to understand why, from the perspective of factor investors, the folks who think these unique risks won't be rewarded going forward are making some sort of error.
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Re: The Bottom Line on Factor Investing

Post by grabiner »

aristotle'sfootprint wrote: Thu Apr 30, 2020 6:06 pm
vineviz wrote: Thu Apr 30, 2020 2:16 pm
acegolfer wrote: Thu Apr 30, 2020 1:51 pm I asked why SCV's recent bad performance is considered as a systematic risk. You answered because of risk factors. Isn't that a tautology?
I think you misunderstood the original claim.

Underperformance can be evidence of a systematic risk: underperformance itself is not the systematic risk.
I hope you all don't mind if I ask a naive question that's maybe a bit prior to this issue. Suppose a risk story for the size and value premiums is true. Is there an intuitive, non-technical way to understand why the existence of unique sources of systematic risk should be associated with *higher* expected returns? I'm trying to understand why, from the perspective of factor investors, the folks who think these unique risks won't be rewarded going forward are making some sort of error.
The intuitive explanation is that investors will not voluntarily take a higher non-diversifiable risk unless they have higher expected returns, so they will trade risky investments at prices which give those higher expected returns. This is why corporate bonds, which may default, have higher yields than Treasury bonds of the same maturity; here, the expected returns are easier to evaluate, because Treasury yields are known, and there is good date on corporate default rates. If small stocks are riskier than large stocks, then investors will only buy them at levels which give higher expected returns.
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Re: The Bottom Line on Factor Investing

Post by BigJohn »

rascott wrote: Thu Apr 30, 2020 12:04 am
BigJohn wrote: Wed Apr 29, 2020 4:52 pm
Blue456 wrote: Wed Apr 29, 2020 1:07 pm The aha moment was realizing that small caps, just like international is a way of diversifying my portfolio.
Not quite the same in my mind. Overweighting small is a diversification from TSM only if it has some return generation mechanism different and independent from the rest of the market. This might be true or it might just be data mining. Or it might have been true 30+ years ago but market changes (eg knowledge and availability of low cost factor funds) may have reduced or eliminated what used to exist.

On the other hand, international is a different set of investments by simple inspection. It doesn’t require the leap of faith that diversification via factors requires.

Nonsense..... just look at the last 20 years. Or 2 years.

Small caps move much, much differently than large. There are many fundamental reasons for this, if you care to get into it.
This ignores the fact that the system a lot of the statistics come from has changed, no guarantee that the the same model still applies.

Regarding the nonsense.. Some sectors move very differently from one another, does that make them independent sources of return? For example, the energy sector has behaved very differently than the market as a whole in the last few year. But I haven’t heard anyone use that as evidence that it’s an independent source of return.

I’m glad you’re a believer and hope it works for you, I’m not so let’s just leave it at that :beer
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Re: The Bottom Line on Factor Investing

Post by rascott »

BigJohn wrote: Thu Apr 30, 2020 8:22 pm
rascott wrote: Thu Apr 30, 2020 12:04 am
BigJohn wrote: Wed Apr 29, 2020 4:52 pm
Blue456 wrote: Wed Apr 29, 2020 1:07 pm The aha moment was realizing that small caps, just like international is a way of diversifying my portfolio.
Not quite the same in my mind. Overweighting small is a diversification from TSM only if it has some return generation mechanism different and independent from the rest of the market. This might be true or it might just be data mining. Or it might have been true 30+ years ago but market changes (eg knowledge and availability of low cost factor funds) may have reduced or eliminated what used to exist.

On the other hand, international is a different set of investments by simple inspection. It doesn’t require the leap of faith that diversification via factors requires.

Nonsense..... just look at the last 20 years. Or 2 years.

Small caps move much, much differently than large. There are many fundamental reasons for this, if you care to get into it.
This ignores the fact that the system a lot of the statistics come from has changed, no guarantee that the the same model still applies.

Regarding the nonsense.. Some sectors move very differently from one another, does that make them independent sources of return? For example, the energy sector has behaved very differently than the market as a whole in the last few year. But I haven’t heard anyone use that as evidence that it’s an independent source of return.

I’m glad you’re a believer and hope it works for you, I’m not so let’s just leave it at that :beer

An "independent source of return" can get very deep into the weeds. The returns of firms located in my county/ state/ region/ country..... may be different than yours.

Something like the SP600 is fairly broad sector based..... but behaves nothing like the SP500 that has similar sectors.

I've owned small caps in overweight proportions for 20+ years....I don't need to data mine to understand how they operate. They are firms much more levered to the main street US economy.... while the SP500 is a global macro lever.

Having a healthy share of both.... along with a large swath of local real estate holdings.... the ultra micro cap.... keeps my world a healthy mix of local/ country/ world. There are periods where one of these is booming while others lagging.

In the 2000s.... it was local, then small caps, then large caps. The last decade has been large caps, local, small caps. Who knows what the next decade will give. One will be at the top, one at the bottom.

International equities create currency risk that's not compensated. As such I only hold about 15%. And don't even much care for that..... though the valuations are starting to look interesting.
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

rascott wrote: Fri May 01, 2020 1:17 am An "independent source of return" can get very deep into the weeds. The returns of firms located in my county/ state/ region/ country..... may be different than yours.

Something like the SP600 is fairly broad sector based..... but behaves nothing like the SP500 that has similar sectors.

I've owned small caps in overweight proportions for 20+ years....I don't need to data mine to understand how they operate. They are firms much more levered to the main street US economy.... while the SP500 is a global macro lever.

Having a healthy share of both.... along with a large swath of local real estate holdings.... the ultra micro cap.... keeps my world a healthy mix of local/ country/ world. There are periods where one of these is booming while others lagging.

In the 2000s.... it was local, then small caps, then large caps. The last decade has been large caps, local, small caps. Who knows what the next decade will give. One will be at the top, one at the bottom.

International equities create currency risk that's not compensated. As such I only hold about 15%. And don't even much care for that..... though the valuations are starting to look interesting.
You just explained that there are different sources of return but you didn't explain why they should be compensated.
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Re: The Bottom Line on Factor Investing

Post by IndexCore »

Elysium wrote: Wed Apr 29, 2020 10:32 am
IndexCore wrote: Wed Apr 29, 2020 10:05 am you're saying a hedge fund charging 2% of assets and 20% of profits is a smaller scam than investing in SPDR S&P 600 Small Cap Value ETF (SLYV) which has a 0.15% expense ratio?
If you are honest, you will know even tiny expense ratios can make a difference when sold in large volumes. Not just that, the number of products available and sold adds to the bottomline, it is designed to capture that money that may flow elsewhere. They are also designed to make securities more widely traded, by ETFs purchasing and selling more number of shares, that creates transactions costs. trading fees, bid/ask spreads for the market makers, traders, brokerages, financial advisors. The Eco system created by more index products / ETFs are much more than the differences in expense ratio. Someone has to be either a novice or disingenuous not to be aware of all this.
Is it honest to remove the key point of my post when quoting me?
IndexCore wrote: Wed Apr 29, 2020 10:05 am
Elysium wrote: Wed Apr 29, 2020 7:10 am Factor investing may be biggest scam where Wall street re-packaged Sector funds, offered a new story, and sold down to gullible investors.
Using the phrase "biggest scam" to describe the main topic of this thread looks to me like trolling.
If you agree costs matter, how can you call factor investing the "biggest scam"?
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Re: The Bottom Line on Factor Investing

Post by aristotle'sfootprint »

grabiner wrote: Thu Apr 30, 2020 6:12 pm
aristotle'sfootprint wrote: Thu Apr 30, 2020 6:06 pm
vineviz wrote: Thu Apr 30, 2020 2:16 pm
acegolfer wrote: Thu Apr 30, 2020 1:51 pm I asked why SCV's recent bad performance is considered as a systematic risk. You answered because of risk factors. Isn't that a tautology?
I think you misunderstood the original claim.

Underperformance can be evidence of a systematic risk: underperformance itself is not the systematic risk.
I hope you all don't mind if I ask a naive question that's maybe a bit prior to this issue. Suppose a risk story for the size and value premiums is true. Is there an intuitive, non-technical way to understand why the existence of unique sources of systematic risk should be associated with *higher* expected returns? I'm trying to understand why, from the perspective of factor investors, the folks who think these unique risks won't be rewarded going forward are making some sort of error.
The intuitive explanation is that investors will not voluntarily take a higher non-diversifiable risk unless they have higher expected returns, so they will trade risky investments at prices which give those higher expected returns. This is why corporate bonds, which may default, have higher yields than Treasury bonds of the same maturity; here, the expected returns are easier to evaluate, because Treasury yields are known, and there is good date on corporate default rates. If small stocks are riskier than large stocks, then investors will only buy them at levels which give higher expected returns.
Thanks for the reply. I think my trouble was with the idea of a unique source of risk, which suggests (to me) that it's different from and not comparable to plain market risk. So, if I'm understanding, that's a mistake. The idea would be that small stocks are riskier than large, where the risk is measured along the same dimension.
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Re: The Bottom Line on Factor Investing

Post by vineviz »

aristotle'sfootprint wrote: Fri May 01, 2020 8:44 am
Thanks for the reply. I think my trouble was with the idea of a unique source of risk, which suggests (to me) that it's different from and not comparable to plain market risk. So, if I'm understanding, that's a mistake. The idea would be that small stocks are riskier than large, where the risk is measured along the same dimension.

No, you had it right the first time.

If small stocks had only the same KIND of risk as large stocks, simply more of it, they'd outperform large stocks when the market is up and underperform large stocks when the market is down. That's not at all what we see.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch
aristotle'sfootprint
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Re: The Bottom Line on Factor Investing

Post by aristotle'sfootprint »

vineviz wrote: Fri May 01, 2020 8:51 am
aristotle'sfootprint wrote: Fri May 01, 2020 8:44 am
Thanks for the reply. I think my trouble was with the idea of a unique source of risk, which suggests (to me) that it's different from and not comparable to plain market risk. So, if I'm understanding, that's a mistake. The idea would be that small stocks are riskier than large, where the risk is measured along the same dimension.

No, you had it right the first time.

If small stocks had only the same KIND of risk as large stocks, simply more of it, they'd outperform large stocks when the market is up and underperform large stocks when the market is down. That's not at all what we see.
OK, thanks. That makes sense. So if it's a qualitatively different kind of a risk, is there an intuitive way to grasp the idea of small stocks as riskier than large? "Riskier" just seems like a quantitative comparison. Or is it a mistake to take the risk story about size to be that small stocks are riskier than large? This all seems pretty fundamental but is also hard to grasp intuitively.
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

aristotle'sfootprint wrote: Fri May 01, 2020 8:44 am Thanks for the reply. I think my trouble was with the idea of a unique source of risk, which suggests (to me) that it's different from and not comparable to plain market risk. So, if I'm understanding, that's a mistake. The idea would be that small stocks are riskier than large, where the risk is measured along the same dimension.
Seems you have a good understanding of CAPM, which states difference in expected return is solely caused by difference in beta. If this were true, the the small stocks and large stocks with the same beta should have the same expected return. But in reality, small stocks had higher average return than big stocks with the same beta. This implied there are more than market risk to explain the return. In other words, systematic risk can't be measured by a single dimension and there are other sources of systematic risks.
acegolfer
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

aristotle'sfootprint wrote: Fri May 01, 2020 9:15 am OK, thanks. That makes sense. So if it's a qualitatively different kind of a risk, is there an intuitive way to grasp the idea of small stocks as riskier than large? "Riskier" just seems like a quantitative comparison. Or is it a mistake to take the risk story about size to be that small stocks are riskier than large? This all seems pretty fundamental but is also hard to grasp intuitively.
Unlike CAPM, there's no economic model to explain how size will affect expected return. You may hear a lot of justifications in forums why small stocks are riskier but it's important to distinguish systematic risk from idiosyncratic risk because only the former matters.
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

I think that in general small stocks have both more market type risk (market beta greater than 1) and unique independent risk of small size. I thought one of the main points of the FF work was to distinguish increased market risk from a different type of risk in small stocks.

Dave
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

acegolfer wrote: Fri May 01, 2020 9:19 am
aristotle'sfootprint wrote: Fri May 01, 2020 9:15 am OK, thanks. That makes sense. So if it's a qualitatively different kind of a risk, is there an intuitive way to grasp the idea of small stocks as riskier than large? "Riskier" just seems like a quantitative comparison. Or is it a mistake to take the risk story about size to be that small stocks are riskier than large? This all seems pretty fundamental but is also hard to grasp intuitively.
Unlike CAPM, there's no economic model to explain how size will affect expected return. You may hear a lot of justifications in forums why small stocks are riskier but it's important to distinguish systematic risk from idiosyncratic risk because only the former matters.
To me the cost of capital story is intuitive. The cost of capital for a company is the expected return of its stock. I would expect a small software company to have to pay a higher interest rate than Microsoft.

Dave
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

Random Walker wrote: Fri May 01, 2020 9:31 am I would expect a small software company to have to pay a higher interest rate than Microsoft.
You just re-stated small firms are riskier. That's not an explanation for why small stocks are riskier.
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

acegolfer wrote: Fri May 01, 2020 9:48 am
Random Walker wrote: Fri May 01, 2020 9:31 am I would expect a small software company to have to pay a higher interest rate than Microsoft.
You just re-stated small firms are riskier. That's not an explanation for why small stocks are riskier.
Well they would have to pay the higher interest rate because the bank is less likely to get paid back. Why would the bank be less likely to get paid back? Because smaller companies have fewer sources of income, more volatile earnings, likely more leveraged, do worse in recessions. The stock is riskier because the underlying firm is riskier. And some of that additional risk is just more market type risk and some of that risk is risk unique to being small.

Dave
Last edited by Random Walker on Fri May 01, 2020 11:17 am, edited 1 time in total.
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Re: The Bottom Line on Factor Investing

Post by raven15 »

MotoTrojan wrote: Wed Apr 29, 2020 7:55 pm
raven15 wrote: Wed Apr 29, 2020 7:24 pm
MotoTrojan wrote: Wed Apr 29, 2020 7:09 pm
raven15 wrote: Wed Apr 29, 2020 6:36 pm
klaus14 wrote: Wed Apr 29, 2020 6:30 pm

Not really. Unless you are rebalancing. You cannot expect positive results from this. Because sometimes you'll buy cheap, sometimes you'll buy expensive and average case they cancel each other.

And that was more than full cycle. Cycle usually ends higher than where it started. Your example was less realistic than mine.
No this is a real thing. It is the inverse of sequence of returns risk which new retirees need to deal with. Positive results are not guaranteed, but they are more likely than negative results.
Positive results are not guaranteed indeed, they are close to 50/50 actually :). You are making some serious mental gymnastics to say that this boosts returns, but over the long-term it should not unless you are contributing to the underweight holding of a pair of (volatile) uncorrelated holdings.
Wrong. If both funds have the same underlying CAGR over a given time frame, then regular purchases of the more volatile fund will* cause an end result of more money. About 0.5% historically. So if SCV has annualized returns of at least 0.5% less than TSM over my period, then I will at least break even in comparison. However, most invested money is owned by people with a lot of wealth who cannot tolerate a lower CAGR especially for a more volatile asset, so I concede that SCV will not have higher risk adjusted returns and maybe not even higher absolute returns; however, I see no reason for it to have lower absolute returns. Of course if factor proponents are right then SCV should have higher returns. We would probably agree that 100% SCV would be a terrible risk for a retiree. Well (mechanically if not always mentally) the inverse of the retiree is true for a newish investor making regular contributions.

*Edit: Ok that is not true, you could get a bad sequence of very high prices and end on a down note. As I said, it is inverse of sequence of returns for a retiree. But just as miscellaneous volatility is bad for a retiree, it is good for an accumulator.
Let’s agree to disagree. I don’t believe there’s a direct inverse scenario to sequence of returns risk in withdrawal phase.
Also please refer to
https://earlyretirementnow.com/2017/05/ ... turn-risk/
which is the best illustration of the concept I know of.
It's Time. Adding Interest.
MotoTrojan
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Re: The Bottom Line on Factor Investing

Post by MotoTrojan »

raven15 wrote: Fri May 01, 2020 10:51 am
MotoTrojan wrote: Wed Apr 29, 2020 7:55 pm
raven15 wrote: Wed Apr 29, 2020 7:24 pm
MotoTrojan wrote: Wed Apr 29, 2020 7:09 pm
raven15 wrote: Wed Apr 29, 2020 6:36 pm
No this is a real thing. It is the inverse of sequence of returns risk which new retirees need to deal with. Positive results are not guaranteed, but they are more likely than negative results.
Positive results are not guaranteed indeed, they are close to 50/50 actually :). You are making some serious mental gymnastics to say that this boosts returns, but over the long-term it should not unless you are contributing to the underweight holding of a pair of (volatile) uncorrelated holdings.
Wrong. If both funds have the same underlying CAGR over a given time frame, then regular purchases of the more volatile fund will* cause an end result of more money. About 0.5% historically. So if SCV has annualized returns of at least 0.5% less than TSM over my period, then I will at least break even in comparison. However, most invested money is owned by people with a lot of wealth who cannot tolerate a lower CAGR especially for a more volatile asset, so I concede that SCV will not have higher risk adjusted returns and maybe not even higher absolute returns; however, I see no reason for it to have lower absolute returns. Of course if factor proponents are right then SCV should have higher returns. We would probably agree that 100% SCV would be a terrible risk for a retiree. Well (mechanically if not always mentally) the inverse of the retiree is true for a newish investor making regular contributions.

*Edit: Ok that is not true, you could get a bad sequence of very high prices and end on a down note. As I said, it is inverse of sequence of returns for a retiree. But just as miscellaneous volatility is bad for a retiree, it is good for an accumulator.
Let’s agree to disagree. I don’t believe there’s a direct inverse scenario to sequence of returns risk in withdrawal phase.
Also please refer to
https://earlyretirementnow.com/2017/05/ ... turn-risk/
which is the best illustration of the concept I know of.
Will have to dig into this deeper, thanks. It was my understanding though that the accumulator’s good and bad sequences would ultimately not matter; a bad period early vs. late doesn’t matter as long as they end at the same price and had the same time-weighted average price during the accumulation period. With the retiree however who is permanently removing value from the portfolio, the order does indeed matter. Hence the net-zero benefit for the accumulator. Either way, I tilt heavily to SCV globally, so I’m a believer in some benefit :).
HootingSloth
Posts: 65
Joined: Mon Jan 28, 2019 3:38 pm

Re: The Bottom Line on Factor Investing

Post by HootingSloth »

Here is the bottom line on factor investing for me:
  • There is strong evidence that the portfolio that is most likely to maximize the Sharpe ratio (i.e., have the best trade-off between "risk" and return where "risk" is, for this purpose, defined solely in terms of variance) over sufficiently long periods of time (>30 years) will have a substantial tilt towards small and value factors.
  • It is likely that this "superior" performance results in significant part from a trade-off between "risk" in the narrowly defined sense of variance and other independent sources of risk.
  • The market portfolio absolutely does have some degree of exposure to these different kinds of risk already, and people that think that investing in factors is diversifying across other, independent sources of risk are effectively mistaking the definition of factors (where the market portfolio always has zero loading on a factor) for the degree of exposure to these different kinds of risk.
  • Just as investors can decide they want to take on more or less exposure to variance-risk by having more or less exposure to stocks than the market portfolio (or by using leverage, or by adding a bunch of TIPS, etc.), investors can take on more or less exposure to these other kinds of risk by tilting towards or away from factors.
  • As a result, it is perfectly rational for an investor to want to tilt towards small and value or towards large and growth, but an investor should have some understanding of why they--as an individual--should take on more or less of a particular kind of risk than the average market participant. If not, then they likely will abandon the strategy if it underperforms for a decade or two.
  • I have not been able to identify a way in which I, as an individual, should take on more or less of the risks associated with small or value stocks (since I do not really have a good understanding of the nature of those risks in the first place).
  • Accordingly, even though I believe a tilt to small and value would very likely lead to a higher Sharpe ratio over the course of my investing life, I have decided to avoid any factor-based tilt. (I do tilt more towards stocks than the market portfolio, being at about 80-20 AA, because I believe I have a somewhat greater ability and willingness to take on variance-risk than the average market participant. I also tilt slightly towards U.S. stocks from the market portfolio, using Siamond's 80% global + 20% domestic allocation, because I believe I want somewhat less exposure to exchange rate risk with currencies other than USD than the average market participant.)
Last edited by HootingSloth on Fri May 01, 2020 11:34 am, edited 1 time in total.
MotoTrojan
Posts: 10659
Joined: Wed Feb 01, 2017 8:39 pm

Re: The Bottom Line on Factor Investing

Post by MotoTrojan »

Just bought a little fun-money amount spread amongst ZIG, QVAL, and IVAL in honor of you all.
acegolfer
Posts: 2284
Joined: Tue Aug 25, 2009 9:40 am

Re: The Bottom Line on Factor Investing

Post by acegolfer »

HootingSloth wrote: Fri May 01, 2020 11:20 am Here is the bottom line on factor investing for me:
  • There is strong evidence that the portfolio that is most likely to maximize the Sharpe ratio (i.e., have the best trade-off between "risk" and return where "risk" is, for this purpose, defined solely in terms of variance) over sufficiently long periods of time (>30 years) will have a substantial tilt towards small and value factors.
  • It is likely that this "superior" performance results in significant part from a trade-off between "risk" in the narrowly defined sense of variance and other independent sources of risk.
  • The market portfolio absolutely does have some degree of exposure to these different kinds of risk already, and people that think that investing in factors is diversifying across other, independent sources of risk are effectively mistaking the definition of factors (where the market portfolio always has zero loading on a factor) for the degree of exposure to these different kinds of risk.
  • Just as investors can decide they want to take on more or less exposure to variance-risk by having more or less exposure to stocks than the market portfolio (or by using leverage, or by adding a bunch of TIPS, etc.), investors can take on more or less exposure to these other kinds of risk by tilting towards or away from factors.
  • As a result, it is perfectly rational for an investor to want to tilt towards small and value or towards large and growth, but an investor should have some understanding of why they--as an individual--should take on more or less of a particular kind of risk than the average market participant. If not, then they likely will abandon the strategy if it underperforms for a decade or two.
  • I have not been able to identify a way in which I, as an individual, should take on more or less of the risks associated with small or value stocks (since I do not really have a good understanding of the nature of those risks in the first place).
  • Accordingly, even though I believe a tilt to small and value would very likely lead to a higher Sharpe ratio over the course of my investing life, I have decided to avoid any factor-based tilt. (I do tilt more towards stocks than the market portfolio, being at about 80-20 AA, because I believe I have a somewhat greater ability and willingness to take on variance-risk than the average market participant. I also tilt slightly towards U.S. stocks from the market portfolio, using Siamond's 80% global + 20% domestic allocation, because I believe I want somewhat less exposure to exchange rate risk with currencies other than USD than the average market participant.)
This is the best post I've read in BH in the last several months.
Fryxell
Posts: 134
Joined: Sat Mar 02, 2013 10:08 pm
Location: Dallas

Re: The Bottom Line on Factor Investing

Post by Fryxell »

I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.

Portfolio Visualizer link: https://www.portfoliovisualizer.com/ba ... ion2_2=100

CAGR; Sharpe Ratio; Max Drawdown

US Stock Market: 7.49%; 0.41; -50.89%
Long-Term Treasuries: 7.68%; 0.56; -16.68%

Many believe that factors such as small and value have been arbitraged away. But there’s an even stronger case to be made that the equity premium itself has been arbitraged away by efficient markets. Indeed, since 2000 the Shiller CAPE has remained at historic highs, consistent with such a hypothesis. By contrast, the valuation gap between value and growth stocks is near historic highs, suggesting that the value premium has not been arbitraged away.

That said, I don’t really believe the equity premium has been arbitraged away. What I am saying is that there is stronger evidence that the equity premium has been arbitraged away than there is that the small/value premium has been arbitraged away. Stocks have underperformed long-term treasuries for a very long time, and with more risk.
Last edited by Fryxell on Sat May 02, 2020 12:49 pm, edited 1 time in total.
oldfort
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Re: The Bottom Line on Factor Investing

Post by oldfort »

Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.
If you look at the Fama-French 3-factor model, for developed countries from 1991-2019, you get these t-stats for annual returns:

equity premium: 2.18
small premium: 0.36
value premium: 1.18

So in the traditional Fama three factor model, the equity premium has a higher degree of statistical significance than the small or value premium.
muffins14
Posts: 359
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Re: The Bottom Line on Factor Investing

Post by muffins14 »

oldfort wrote: Sat May 02, 2020 1:00 am
Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.
If you look at the Fama-French 3-factor model, for developed countries from 1991-2019, you get these t-stats for annual returns:

equity premium: 2.18
small premium: 0.36
value premium: 1.18

So in the traditional Fama three factor model, the equity premium has a higher degree of statistical significance than the small or value premium.
Do you also have the associated point estimates of the premia? The t-stat alone doesn’t inform us about the magnitude of the premia, just the confidence that it’s non-zero.
DonIce
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Re: The Bottom Line on Factor Investing

Post by DonIce »

Random Walker wrote: Fri May 01, 2020 10:24 am
acegolfer wrote: Fri May 01, 2020 9:48 am
Random Walker wrote: Fri May 01, 2020 9:31 am I would expect a small software company to have to pay a higher interest rate than Microsoft.
You just re-stated small firms are riskier. That's not an explanation for why small stocks are riskier.
Well they would have to pay the higher interest rate because the bank is less likely to get paid back. Why would the bank be less likely to get paid back? Because smaller companies have fewer sources of income, more volatile earnings, likely more leveraged, do worse in recessions. The stock is riskier because the underlying firm is riskier. And some of that additional risk is just more market type risk and some of that risk is risk unique to being small.

Dave
What is the risk story for the momentum factor? How about the quality factor? Or the minimum volatility "anomaly"? Some of these have higher "statistical significance" in the data than the small and value factors, despite their "risk stories" being far less "compelling".

I think all of them are merely data mining artifacts, including small and value factors. You look through giant piles of data and you are guaranteed to find patterns and correlations; that's just how randomness works.
DonIce
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Re: The Bottom Line on Factor Investing

Post by DonIce »

Fryxell wrote: Sat May 02, 2020 12:31 am Many believe that factors such as small and value have been arbitraged away. But there’s an even stronger case to be made that the equity premium itself has been arbitraged away by efficient markets. Indeed, since 2000 the Shiller CAPE has remained at historic highs, consistent with such a hypothesis. By contrast, the valuation gap between value and growth stocks is near historic highs, suggesting that the value premium has not been arbitraged away.
There will always be a valuation gap between the top half of companies by P/B and the bottom half of companies by P/B (or whatever other metric). Obviously, not all companies should sell at the same P/B or P/E. Some companies have better prospects than others, and they are priced differently accordingly. The outperformance of "value" stocks would occur not just from a difference in valuation, but from an *erroneous" difference in valuation. That is, there must be some companies in the value camp that are actually gonna outperform expectations, and have their valuation go up considerably, for the value "factor" outperformance to show up. So the valuation gap can widen and widen, but as long as the expectations for value stocks are correct and they don't actually outperform expectations, no "premium" will ever show up.
User avatar
Uncorrelated
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Re: The Bottom Line on Factor Investing

Post by Uncorrelated »

muffins14 wrote: Sat May 02, 2020 2:16 am
oldfort wrote: Sat May 02, 2020 1:00 am
Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.
If you look at the Fama-French 3-factor model, for developed countries from 1991-2019, you get these t-stats for annual returns:

equity premium: 2.18
small premium: 0.36
value premium: 1.18

So in the traditional Fama three factor model, the equity premium has a higher degree of statistical significance than the small or value premium.
Do you also have the associated point estimates of the premia? The t-stat alone doesn’t inform us about the magnitude of the premia, just the confidence that it’s non-zero.
Over the time period July 1963–December 2013
Image
Source: Fama, French, A five-factor asset pricing model, 2014


long only:
Image
Source: Fama, French, The Value Premium, 2020

They don't report the long-short factor results. When interpreting this paper, it is important to remember that the international factor performance has been much stronger.

International, July 1992 –December 2014,
Image
Source: Cakici, Nusret. (2015). The Five-Factor Fama-French Model: International Evidence. SSRN Electronic Journal. 10.2139/ssrn.2601662.

In north america in this time period, MKT is statistically significant but HML isn't. In europe, japan and asia-pacific, it's the other way around.
Random Walker
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

DonIce wrote: Sat May 02, 2020 3:24 am
Random Walker wrote: Fri May 01, 2020 10:24 am
acegolfer wrote: Fri May 01, 2020 9:48 am
Random Walker wrote: Fri May 01, 2020 9:31 am I would expect a small software company to have to pay a higher interest rate than Microsoft.
You just re-stated small firms are riskier. That's not an explanation for why small stocks are riskier.
Well they would have to pay the higher interest rate because the bank is less likely to get paid back. Why would the bank be less likely to get paid back? Because smaller companies have fewer sources of income, more volatile earnings, likely more leveraged, do worse in recessions. The stock is riskier because the underlying firm is riskier. And some of that additional risk is just more market type risk and some of that risk is risk unique to being small.

Dave
What is the risk story for the momentum factor? How about the quality factor? Or the minimum volatility "anomaly"? Some of these have higher "statistical significance" in the data than the small and value factors, despite their "risk stories" being far less "compelling".

I think all of them are merely data mining artifacts, including small and value factors. You look through giant piles of data and you are guaranteed to find patterns and correlations; that's just how randomness works.
I think momentum is all behavioral, no risk story. I’ve read at least one risk story behind profitability/quality involving increased likelihood of attracting competition. That risk story sounds pretty tenuous to me. I appreciate that people have been questioning small. But I also appreciate that screening out the small companies with high investment and low profitability makes small more significant. My strongest belief (besides market factor) is in value. My strong belief in it stems from it having both risk and behavioral rationale supporting it. My interest in small is partly due to the fact that intuitively to me smaller companies would be more risky. But also, all the other factor premia (especially value) appear to me more significant in the small stocks.

Dave
Park
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Re: The Bottom Line on Factor Investing

Post by Park »

DonIce wrote: Sat May 02, 2020 3:34 am
Fryxell wrote: Sat May 02, 2020 12:31 am Many believe that factors such as small and value have been arbitraged away. But there’s an even stronger case to be made that the equity premium itself has been arbitraged away by efficient markets. Indeed, since 2000 the Shiller CAPE has remained at historic highs, consistent with such a hypothesis. By contrast, the valuation gap between value and growth stocks is near historic highs, suggesting that the value premium has not been arbitraged away.
There will always be a valuation gap between the top half of companies by P/B and the bottom half of companies by P/B (or whatever other metric). Obviously, not all companies should sell at the same P/B or P/E. Some companies have better prospects than others, and they are priced differently accordingly. The outperformance of "value" stocks would occur not just from a difference in valuation, but from an *erroneous" difference in valuation. That is, there must be some companies in the value camp that are actually gonna outperform expectations, and have their valuation go up considerably, for the value "factor" outperformance to show up. So the valuation gap can widen and widen, but as long as the expectations for value stocks are correct and they don't actually outperform expectations, no "premium" will ever show up.
If there are two companies, which are very similar except for risk, I"m going to expect a higher return for the more risky company. That higher expected return will result in lower price multiples, such as a lower P/B.

Risk is not the only reason for lower price multiples, as you point out. But it is one.
Random Walker
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

DonIce wrote: Sat May 02, 2020 3:24 am
Random Walker wrote: Fri May 01, 2020 10:24 am
acegolfer wrote: Fri May 01, 2020 9:48 am
Random Walker wrote: Fri May 01, 2020 9:31 am I would expect a small software company to have to pay a higher interest rate than Microsoft.
You just re-stated small firms are riskier. That's not an explanation for why small stocks are riskier.
Well they would have to pay the higher interest rate because the bank is less likely to get paid back. Why would the bank be less likely to get paid back? Because smaller companies have fewer sources of income, more volatile earnings, likely more leveraged, do worse in recessions. The stock is riskier because the underlying firm is riskier. And some of that additional risk is just more market type risk and some of that risk is risk unique to being small.

Dave
What is the risk story for the momentum factor? How about the quality factor? Or the minimum volatility "anomaly"? Some of these have higher "statistical significance" in the data than the small and value factors, despite their "risk stories" being far less "compelling".

I think all of them are merely data mining artifacts, including small and value factors. You look through giant piles of data and you are guaranteed to find patterns and correlations; that's just how randomness works.
I agree that data mining is a huge concern. But is there a point where one has enough data to place his bets? We can look at a data set and extract a factor from it. Then we can do out of sample tests. These tests can be different time periods, different geographical markets, and even in some cases different asset classes. For example, I agree with suspicion regarding behavioral momentum factor. But it shows up everywhere: stocks, bonds, commodities, currencies. If my memory serves me right, even sports betting. Is there a point where the data can overcome data mining? I really don’t know, but I’ve invested as though there is.

Dave
Random Walker
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.

Portfolio Visualizer link: https://www.portfoliovisualizer.com/ba ... ion2_2=100

CAGR; Sharpe Ratio; Max Drawdown

US Stock Market: 7.49%; 0.41; -50.89%
Long-Term Treasuries: 7.68%; 0.56; -16.68%

Many believe that factors such as small and value have been arbitraged away. But there’s an even stronger case to be made that the equity premium itself has been arbitraged away by efficient markets. Indeed, since 2000 the Shiller CAPE has remained at historic highs, consistent with such a hypothesis. By contrast, the valuation gap between value and growth stocks is near historic highs, suggesting that the value premium has not been arbitraged away.

That said, I don’t really believe the equity premium has been arbitraged away. What I, saying is that there is stronger evidence that the equity premium has been arbitraged away than there is that the small/value premium has been arbitraged away. Stocks have underperformed long-term treasuries for a very long time, and with more risk.

The above is a great post whether one Is a factor fan or not! To add a smidge to it, I believe the equity market has under performed treasuries for at least 12-13 years on 3 occassions since 1926: 1929-1943, 1966-1982, 2000-2012.

Dave
redbarn
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Re: The Bottom Line on Factor Investing

Post by redbarn »

Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.
If the argument for investing in equity was merely the case for investing in a beta factor in a CAPM or multi-factor model that was backed by past performance regressions, then I agree it would be on rather thin ice. But the case for why there should be an equity premium in expectation can be made entirely independently of financial economics theories, based on how businesses operate and the differences between how stocks and bonds work.
acegolfer
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

Park wrote: Sat May 02, 2020 9:43 am If there are two companies, which are very similar except for risk, I"m going to expect a higher return for the more risky company.
This is true, only if the market compensates for that risk. However, not all risks such as idiosyncratic risks are compensated.
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imak
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Re: The Bottom Line on Factor Investing

Post by imak »

HootingSloth wrote: Fri May 01, 2020 11:20 am Here is the bottom line on factor investing for me:
  • There is strong evidence that the portfolio that is most likely to maximize the Sharpe ratio (i.e., have the best trade-off between "risk" and return where "risk" is, for this purpose, defined solely in terms of variance) over sufficiently long periods of time (>30 years) will have a substantial tilt towards small and value factors.
  • It is likely that this "superior" performance results in significant part from a trade-off between "risk" in the narrowly defined sense of variance and other independent sources of risk.
  • The market portfolio absolutely does have some degree of exposure to these different kinds of risk already, and people that think that investing in factors is diversifying across other, independent sources of risk are effectively mistaking the definition of factors (where the market portfolio always has zero loading on a factor) for the degree of exposure to these different kinds of risk.
  • Just as investors can decide they want to take on more or less exposure to variance-risk by having more or less exposure to stocks than the market portfolio (or by using leverage, or by adding a bunch of TIPS, etc.), investors can take on more or less exposure to these other kinds of risk by tilting towards or away from factors.
  • As a result, it is perfectly rational for an investor to want to tilt towards small and value or towards large and growth, but an investor should have some understanding of why they--as an individual--should take on more or less of a particular kind of risk than the average market participant. If not, then they likely will abandon the strategy if it underperforms for a decade or two.
  • I have not been able to identify a way in which I, as an individual, should take on more or less of the risks associated with small or value stocks (since I do not really have a good understanding of the nature of those risks in the first place).
  • Accordingly, even though I believe a tilt to small and value would very likely lead to a higher Sharpe ratio over the course of my investing life, I have decided to avoid any factor-based tilt. (I do tilt more towards stocks than the market portfolio, being at about 80-20 AA, because I believe I have a somewhat greater ability and willingness to take on variance-risk than the average market participant. I also tilt slightly towards U.S. stocks from the market portfolio, using Siamond's 80% global + 20% domestic allocation, because I believe I want somewhat less exposure to exchange rate risk with currencies other than USD than the average market participant.)
Quite insightful summary! Thanks for sharing.
AA: 30% FNDX, 30% FNDA, 10% FNDF, 10% FNDC, 10% REET+VWO+DGS, 10% TMF; EF = VTEB; "Discipline matters more than allocation" ~ W Bernstein
acegolfer
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Re: The Bottom Line on Factor Investing

Post by acegolfer »

redbarn wrote: Sat May 02, 2020 10:23 am
Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.
If the argument for investing in equity was merely the case for investing in a beta factor in a CAPM or multi-factor model that was backed by past performance regressions, then I agree it would be on rather thin ice. But the case for why there should be an equity premium in expectation can be made entirely independently of financial economics theories, based on how businesses operate and the differences between how stocks and bonds work.
Well said. One should make an investment decision not just based on data but also on rational explanation. It is easier to explain market factor premium than other factor premiums. (I'm not claiming other factor premiums don't exist.)
oldfort
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Re: The Bottom Line on Factor Investing

Post by oldfort »

muffins14 wrote: Sat May 02, 2020 2:16 am
oldfort wrote: Sat May 02, 2020 1:00 am
Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.
If you look at the Fama-French 3-factor model, for developed countries from 1991-2019, you get these t-stats for annual returns:

equity premium: 2.18
small premium: 0.36
value premium: 1.18

So in the traditional Fama three factor model, the equity premium has a higher degree of statistical significance than the small or value premium.
Do you also have the associated point estimates of the premia? The t-stat alone doesn’t inform us about the magnitude of the premia, just the confidence that it’s non-zero.
You can find the raw data here: https://mba.tuck.dartmouth.edu/pages/fa ... brary.html. To answer your question:

equity - 7.19%
small - 0.56%
value - 2.83%
Random Walker
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Re: The Bottom Line on Factor Investing

Post by Random Walker »

simplesauce wrote: Thu Apr 30, 2020 12:12 pm
Taylor Larimore wrote: Thu Apr 30, 2020 11:53 am
Dave wrote: shouldn’t greater risk be associated with increased expected return?
Dave:

Many years ago when we were invested with Merrill Lynch, our "Advisor" recommended the Merrill Lynch Phenix Fund which we purchased. His primary selling point was that this fund invested in risky companies that were expected to become winners. He was wrong and the Phenix Fund folded along with most of our investment.

I also remember when the risky Vanguard Gold Fund had the BEST 10-year performance of all Vanguard Funds. During the next 10 years it had the WORST performance of all Vanguard funds. It subsequently changed its name to the "Gold and Precious Metals Fund."

It is very dangerous to assume that greater risk will result in increased expected return. There is no better example than the current dismal performance of risky Small Cap Value Funds.

Best wishes.
Taylor
Jack Bogle's Words of Wisdom: "Investors seem hell-bent on carrying out the search for winning funds of the future, no matter how futile the search has proven to be."
Thank you Taylor!
This is why it is important to look at the portfolio as a whole. Two investors may have all their equities in SV. One is 100% SV, one is 20% SV / 80% safe bonds. Really can’t comment on the SV without appreciating its context within the portfolio.

Dave
User avatar
Taylor Larimore
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"Factor Investing"

Post by Taylor Larimore »

Bogleheads:

Several years ago I made a post giving my thoughts about "factor investing." This is the link:

FACTOR INVESTING

Best wishes
Taylor
Jack Bogle's Words of Wisdom: "By and large I do not approve of factor funds."
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Park
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Joined: Sat Nov 06, 2010 4:56 pm

Re: The Bottom Line on Factor Investing

Post by Park »

acegolfer wrote: Sat May 02, 2020 10:32 am
Park wrote: Sat May 02, 2020 9:43 am If there are two companies, which are very similar except for risk, I"m going to expect a higher return for the more risky company.
This is true, only if the market compensates for that risk. However, not all risks such as idiosyncratic risks are compensated.
There are few who doubt that there is an equity risk premium. The expected return for stocks is greater than that of bond, due to the increased risk associated with stocks. That increased risk of stocks can't be diversified away.

There are few who think that bonds are homogeneous in risk. Bonds vary in risk, and some of that risk can't be diversified away. For bonds with greater credit or duration risk, expected return is greater. For duration risk up to medium term and credit risk varying from AAA to BB, I believe the historical data shows increased return. Those who are more knowledgeable can correct me on that. I believe that the relationship going past medium term breaks down, in part because there are bond investors (insurance companies, pension funds etc.), whose priority is not maximizing risk adjusted returns. About the data for bonds lower than BB credit rating, I believe that behavioral reasons (lottery ticket mentality) plays a role. Once again, please feel free to correct me on that.

Why am I talking about bonds? If bonds vary in risk and investors expect increased return for bonds of greater risk, then I don't see how stocks can be different than bonds. Stocks can't be homogeneous in risk. Despite the equity risk premium, there are some stocks that are lower risk than some bonds. Stocks vary in risk, and I don't see how all that variation in risk can be diversified away. There are about 3500 stocks in VTI, Vanguard's US total stock market index fund. If I own the 350 most risky stocks of those 3500 stocks, the addition of more stocks will decrease my risk. But since those additional stocks will be less risky, my expected return will also be less.

The metrics commonly used to differentiate bond risk are term and credit risk. What metrics can be used to differentiate stock risk?

If I invest in a portfolio of stocks of greater risk, I expect a greater return for taking that risk. How will that greater expected return manifest itself? I will expect greater cash flows (profit, capital return (dividends, buyback) etc.) for each dollar that I've invested. That means lower price multiples for such stocks, and lower price multiples means value stocks.

If you invest in value stocks, you must expect the relationship between value and return to be noisy. First of all, you're taking greater risk. There will be times when that risk shows up, and your returns will suffer as a result. Secondly, price ratios are a blunt instrument to differentiate stocks based on risk. There will be stocks that are higher risk, but because of higher expected growth, will be classified as growth stocks. Similarly, there will be stocks that are lower risk, but because of lower expected growth, will be classified as value stocks. And just like the bond market, behavioral reasons will also come into play. An example would be bubbles. But there are those who make good arguments for a behaviorial basis to the value premium, so behavioral reasons may help you. And there are probably fewer stock market investors, compared to bond investors, whose priority is other than maximizing risk adjusted returns.
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packer16
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Re: The Bottom Line on Factor Investing

Post by packer16 »

Fryxell wrote: Sat May 02, 2020 12:31 am I think people should invest in what they believe in. If you don’t believe in factors, then don’t do it.

But I can’t help but notice the double standard between views regarding the various stock factors and the equity premium itself, which is actually another factor. Factor skeptics curiously have an unshakable faith in the equity premium, even though equities have underperforned longer than small value stocks have.

The US stock market underperformed long-term treasuries from January 1997 through March 2020. That is 23 years. That’s a very long time and longer than the underperformance of the value factor. To add insult to injury, treasuries had much lower risk during the period. During this period, stocks have provided risk with no outperformance.

Portfolio Visualizer link: https://www.portfoliovisualizer.com/ba ... ion2_2=100

CAGR; Sharpe Ratio; Max Drawdown

US Stock Market: 7.49%; 0.41; -50.89%
Long-Term Treasuries: 7.68%; 0.56; -16.68%

Many believe that factors such as small and value have been arbitraged away. But there’s an even stronger case to be made that the equity premium itself has been arbitraged away by efficient markets. Indeed, since 2000 the Shiller CAPE has remained at historic highs, consistent with such a hypothesis. By contrast, the valuation gap between value and growth stocks is near historic highs, suggesting that the value premium has not been arbitraged away.

That said, I don’t really believe the equity premium has been arbitraged away. What I, saying is that there is stronger evidence that the equity premium has been arbitraged away than there is that the small/value premium has been arbitraged away. Stocks have underperformed long-term treasuries for a very long time, and with more risk.
The difference is the stocks have a subordinate claim to bonds, like comparing IG bonds to treasuries. You expect IG bonds to yield a higher returns than treasuries because the government has a claim ahead of bondholders (taxes). Value & other factors have no structural differences like stocks vs. bonds. Also. you have a turnover issue. For stock index funds, you have a turnover of 4% per year (so the portfolio turns in 25 years - so you have a consistent group of companies) but with factor funds you have higher turnover (about 19% with SCV so the portfolio turns every 5 years - so you have a different set of underlying companies every 5 years) & you have different implementations of factors which also can lead to leakage of potential returns. On the surface, factors appear a promising source of returns, once you look "under the hood" of what is in these funds & consider the turnover & implementation issues, IMO the benefits become unclear & may be detrimental, especially if a group of people think these stocks have some ability to create excess returns when in fact they do not (the Emperor has No Clothes effect).

Packer
Buy cheap and something good might happen
Park
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Re: The Bottom Line on Factor Investing

Post by Park »

packer16 wrote: Sat May 02, 2020 1:03 pm especially if a group of people think these stocks have some ability to create excess returns when in fact they do not (the Emperor has No Clothes effect).

Packer
Your point is well taken. Value stocks don't have an inherent ability to create excess returns; it is the pricing of value stocks that can result in increased expected returns. If these stocks become more popular, relative to the rest of the stock market, they will become overpriced. And overpricing means decreased expected returns. But unlike growth stocks, there is some limitation as to how much of a bubble you can get in value stocks.

An overpriced value stock will tend to become a growth stock. An overpriced growth stock will tend to stay a growth stock. An underpriced value stock will tend to stay a value stock. An underpriced growth stock will tend to become a value stock.

There is a price to pay, for what is written in the last paragraph. There is more of a limitation on how much a value stock can grow, versus a growth stock. If you plan to stick to value stocks, it's going to be difficult to own 10 bagger stocks.
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