More Evidence Against Factor Investing

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BetaTracker
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More Evidence Against Factor Investing

Post by BetaTracker »

New research by three professors seems to open a major hole in factor investing's reliability in explaining expected returns. The paper is here:
https://d1e00ek4ebabms.cloudfront.net/p ... 3d2475.pdf
It showed how the returns of several big factor drivers of investment returns could vary all over the place, and be highly dependent on what timeframe one measured. Isn't that what Bogle used to argue, too?
Here is the paper's intro:
"The Fama-French factors are ubiquitous in empirical finance. We find that factor returns differ substantially depending on when the data were downloaded, and only a small portion of these retroactive changes is explained by revisions to the underlying data. We show that these changes have large effects in two widely-studied contexts: mutual fund performance and cross-sectional equity pricing. Model evaluation tests suggest that more recent vintages do not perform better. Our findings have significant implications for the integrity of finance research and underscore the importance of understanding the provenance of third-party data."
It continues by stating the authors "do not believe that academic finance can justify the continued use of French’s factors ... Moreover, we do not believe that there is a viable econometric or statistical solution that can salvage French’s factors. The evidence does not support the conclusion that the “noise” we document is, or can be reasonably approximated by, classical measurement error."
The Financial Times noted these findings the other day. In a column by Robin Wigglesworth, he pointed out that this new research has created enough talk in the academic community to spur Fama and French to apparently respond with their own paper. It can be found here:
https://d1e00ek4ebabms.cloudfront.net/p ... acfb1f.pdf
As Wigglesworth highlights, Fama and French didn't directly take on this new research. But they did put a lot of effort into updating the strength of different factors and taking a swing at the "noise" argument, notably lowering the predictive results for small while increasing the risk premia for value. The new Fama-French paper then ends with:
"The details of factor construction are arguable, and there is no magic. After decades of experience, asset pricing research clearly recognizes that factor models, no matter how constructed, leave holes in the explanation of expected asset returns. Moreover, parameter instability and statistical estimation error combine to imply that expected return estimates for specific assets or portfolios from asset pricing models are unreliable. The appropriate caveat is: use at your own risk."
The FT article puts everything into a very understandable context, and draws from comments of other noted quant types. It's well worth a read:
https://www.ft.com/content/2e87e7f9-c2a ... pe=nongift
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Re: More Evidence Against Factor Investing

Post by nisiprius »

Thanks so much for calling the forum's attention to this.

Oh, my:
Our findings have significant implications for the integrity of finance research and
underscore the importance of understanding the provenance of third-party data.
That seems like a bombshell.

Mathias Hasler found that
the construction of the original [Fama and French HmL] portfolio includes six seemingly innocuous decisions. And I was thinking about these decisions, and I was thinking about alternatives that are just as reasonable as these decisions themselves, right?
And he found that the alternatives used by Fama and French yielded a much higher value for the value premium, than the average results of all possible choice between six decisions between each of them and an equally reasonable innocuous alternative. But he never suggests that the higher value was the result of anything but luck.

But this new paper seems to be getting nasty. It gets awfully close to wondering out loud whether Kenneth French fudges his methodology in order to make DFA's approach look good.
BetaTracker wrote: Mon Jan 15, 2024 1:04 pm As Wigglesworth highlights, Fama and French didn't directly take on this new research. But they did put a lot of effort into updating the strength of different factors and taking a swing at the "noise" argument, notably lowering the predictive results for small while increasing the risk premia for value.
The size factor, discovered in 1981, is the granddaddy of all factors. Nobody in the factor crowd is willing to come right out and say that it doesn't exist and never did, but it sure ain't what it was.
Last edited by nisiprius on Mon Jan 15, 2024 2:11 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

nisiprius wrote: Mon Jan 15, 2024 1:37 pm Oh, my:
Our findings have significant implications for the integrity of finance research and
underscore the importance of understanding the provenance of third-party data.
That seems like a bombshell.

Mathias Hasler found that
the construction of the original [Fama and French HmL] portfolio includes six seemingly innocuous decisions. And I was thinking about these decisions, and I was thinking about alternatives that are just as reasonable as these decisions themselves, right?
And he found that the alternatives used by Fama and French yielded a much higher value for the value premium, than the average results from choosing all possible combinations of those six decisions between each choice and a reasonable alternative. He never suggests that the higher value was the result of anything but luck.

But this new paper seems to be getting nasty. It gets awfully close to wondering out loud whether Kenneth French fudges his methodology in order to make DFA's approach look good.
BetaTracker wrote: Mon Jan 15, 2024 1:04 pm As Wigglesworth highlights, Fama and French didn't directly take on this new research. But they did put a lot of effort into updating the strength of different factors and taking a swing at the "noise" argument, notably lowering the predictive results for small while increasing the risk premia for value.
The size factor, discovered in 1981, is the granddaddy of all factors. Nobody in the factor crowd is willing to come right out and say that it doesn't exist and never did, but it sure ain't what it was.
We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
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Re: More Evidence Against Factor Investing

Post by abc132 »

Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm
We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
I guess I would ask why 4 years is significant when 15 years was not.

Either 4 years is noise or it is not noise.

Pick one.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

abc132 wrote: Mon Jan 15, 2024 2:16 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm
We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
I guess I would ask why 4 years is significant when 15 years was not.

Either 4 years is noise or it is not noise.

Pick one.
If they went away, then the last 4 years shouldn’t exist

We have all those live funds showing it since their inception.
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Re: More Evidence Against Factor Investing

Post by nisiprius »

Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
Have they? Could you please state a good, mainstream, typical factor portfolio, with tickers and percentages, that would have been approved by factor enthusiasts just before the start of 2020, and compare it with a Bogleheads three-fund using the same percentages for US stocks, international stocks, and bonds.

Here's what I get when I tried this exercise using the Bill Schultheis Coffee House portfolio, which is a simplified factor portfolio with restrained tilts.

Source

Image

It doesn't look to me as if the last four years have been particularly good for factor investing, but maybe I need to slot in AVUV or something to see it.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

nisiprius wrote: Mon Jan 15, 2024 2:22 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
Have they? Could you please state a good, mainstream, typical factor portfolio, with tickers and percentages, that would have been approved by factor enthusiasts just before the start of 2020, and compare it with a Bogleheads three-fund using the same percentages for US stocks, international stocks, and bonds.

Here's what I get when I tried this exercise using the Bill Schultheis Coffee House portfolio, which is a simplified factor portfolio with restrained tilts.

Source

Image

It doesn't look to me as if the last four years have been particularly good for factor investing, but maybe I need to slot in AVUV or something to see it.
https://www.portfoliovisualizer.com/bac ... Vsb9uXuEN8

VT vs a similarly constructed all SCV portfolio

3% annualized premium over the last 4 years
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Re: More Evidence Against Factor Investing

Post by nisiprius »

While you were doing that, I made a comparison of the portfolio in Nathan Drake's sig, compared with a VTI/VXUS portfolio with the same allocations to US and international. In this case, yes, Nathan Drake's factor portfolio did do better over the last four years than the untilted two-funder.

Source

Image
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

nisiprius wrote: Mon Jan 15, 2024 2:33 pm While you were doing that, I made a comparison of the portfolio in Nathan Drake's sig, compared with a VTI/VXUS portfolio with the same allocations to US and international. In this case, yes, Nathan Drake's factor portfolio did do better over the last four years than the untilted two-funder.

Source

Image
Not a big difference but this is showing two years, constrained by AVES launching in 2022

DFEVX (DFA) is a good proxy for AVES (Avantis)

Longer term back tests can sub DFSVX for AVUV and DISVX for AVDV
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Re: More Evidence Against Factor Investing

Post by BetaTracker »

Another issue is that returns for factor funds like DFA's small cap value and large value funds only go back to 1993, and more varied asset classes like int'l developed SC and emerging markets SC/value have much shorter times to examine ... and I believe DFA only started using profitability in 2012, among other factors.
Last edited by BetaTracker on Tue Jan 16, 2024 5:40 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

BetaTracker wrote: Mon Jan 15, 2024 2:42 pm The advisor I get through work recommends huge tilts to small and almost all value (similar to Mr. Drake's). I like to compare their moderate (60/40) model portfolio to the appropriate Vanguard LifeStrategy fund. Over the past five years, the LifeStrategy portfolio has slightly done better ... the factor tilts really start to show if dates are moved 15-20 years back, but even then the tilts have to be extreme to make a real difference. Another issue is that returns for factor funds like DFA's small cap value and large value funds only go back to 1993, and more varied asset classes like int'l developed SC and emerging markets SC/value have much shorter times to examine ... and I believe DFA only started using profitability in 2012, among other factors.
I don’t think factor advocates would suggest MCW is a bad choice. It’s perfectly fine

Factor enthusiasts are simply willing to bear higher risk for higher potential return, and also believe in the diversification benefits and less time date sensitivity

Even small premiums of .5% over a long enough time add up to quite a big difference.
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Re: More Evidence Against Factor Investing

Post by abc132 »

Nathan Drake wrote: Mon Jan 15, 2024 2:19 pm
abc132 wrote: Mon Jan 15, 2024 2:16 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm
We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
I guess I would ask why 4 years is significant when 15 years was not.

Either 4 years is noise or it is not noise.

Pick one.
If they went away, then the last 4 years shouldn’t exist

We have all those live funds showing it since their inception.
With that logic we can't have a 4 year period where bonds outperform stocks without there being no stock premium. A premium can go away and we can still have 4 years of overperformance. The previous factor argument was that we needed more than 15 years to be able to declare a premium.

I am having trouble with the one-sidedness of the factor argument. 4 years is enough to declare the premium when they are winning but at least 20 years is needed when they are losing?

I am not opposed to the existence of factors or factor investing but this use of logic is surprising.
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Re: More Evidence Against Factor Investing

Post by SB1234 »

I find that Factor Investing is insidious, because it fools you, seduces you, cons you into thinking that you can beat the market.
And even if you beat the market who are you really beating, you think you're pulling a fast one on Wall Street but more likely you just took money from your fellow investor.
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Re: More Evidence Against Factor Investing

Post by nedsaid »

McQ had a very good thread on Factor investing and I was proud to have participated. My conclusion was that if you got
into Small Value before 2002, you would still show a premium today; the earlier you were able to get in, the higher the premium. Unfortunately, I started my Small Value tilt in 2007 which was about the worst possible time to do this.

I took data from the Ken French webpage and converted the annual returns into return on $10,000 so that I could calculate Compound Annual Growth Rate. This data was from 1964 through 2016. Here are both average returns and CAGR over the 53 years. So for whatever it is worth, here is what I found. When I first posted this, I made an error on the spreadsheet which overstated the returns of the risk free rate but have since fixed that.

Market minus Risk Free (Market Factor)
Growth of $10,000 over 53 years equals $139,210
Compound Annual Growth Rate equals 5.09% (Actual Market Factor return)
Average Returns equals 6.62%

Small minus Big (Size Factor)
Growth of $10,000 over 53 years equals $45,460
Compound Annual Growth Rate equals 2.90% (Theoretical Avg. Long/Short Return)
Average Returns equals 3.81%

High minus Low (Value Factor)
Growth of $10,000 over 53 years equals $84,727
Compound Annual Growth Rate equals 4.11% (Theoretical Avg. Long/Short Return)
Average Returns equals 5.03%

Robust minus Weak (Profitability Factor)
Growth of $10,000 over 53 years equals $38,974
Compound Annual Growth Rate equals 2.6% (Theoretical Avg. Long/Short Return)
Average Returns equals 3.06%

Conservative Minus Aggressive (Investment Factor)
Growth of $10,000 over 53 years equals $71,454
Compound Annual Growth Rate equals 3.78% (Theoretical Avg. Long/Short Return)
Average Returns equals 4.01%

Risk Free Rate
Growth of $10,000 over 53 years equals $121,388
Compound Annual Growth Rate equals 4.82% (Actual long only combined Size, Value, Profitability, Investment factor returns)
Average Returns equals 4.87%

Stock Market
Growth of $10,000 over 53 years equals $1,583,139
Compound Annual Growth Rate equals 10.03%
Average Returns equals 11.496%

You can see there is a big difference between average returns and CAGR.
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Re: More Evidence Against Factor Investing

Post by tetractys »

Hasn’t it always been standard practice for factor investing to be wedded to Modern Portfolio Theory (MPT) in order for it to be effective? Why does it seem like everybody arguing against the factors throw out the all important rebalancing part?
Last edited by tetractys on Mon Jan 15, 2024 3:04 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

abc132 wrote: Mon Jan 15, 2024 2:56 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:19 pm
abc132 wrote: Mon Jan 15, 2024 2:16 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm
We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
I guess I would ask why 4 years is significant when 15 years was not.

Either 4 years is noise or it is not noise.

Pick one.
If they went away, then the last 4 years shouldn’t exist

We have all those live funds showing it since their inception.
With that logic we can't have a 4 year period where bonds outperform stocks without there being no stock premium. A premium can go away and we can still have 4 years of overperformance. The previous factor argument was that we needed more than 15 years to be able to declare a premium.

I am having trouble with the one-sidedness of the factor argument. 4 years is enough to declare the premium when they are winning but at least 20 years is needed when they are losing?

I am not opposed to the existence of factors or factor investing but this use of logic is surprising.
I’m not arguing whether there’s a premium of stocks to bonds. I would expect periods of underperformance occasionally

The longest term data of live funds AND the last few years shows a premium and lesser correlation to the market
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Re: More Evidence Against Factor Investing

Post by djm2001 »

I am a vanilla market cap investor but the idea that factor returns are sensitive to small changes in selection and measurement criteria makes me worry a little about whether there's a similar issue with float adjustment. Different indices adjust for public float differently (for example, float adjustment in FTSE indexes appears to be significantly quantitatively different from S&P indexes), and I wonder how sensitive index returns are to that. Basically to what extent is float adjustment another flavor of the same problem that factor construction faces?
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Re: More Evidence Against Factor Investing

Post by abc132 »

Nathan Drake wrote: Mon Jan 15, 2024 3:03 pm I’m not arguing whether there’s a premium of stocks to bonds. I would expect periods of underperformance occasionally

The longest term data of live funds AND the last few years shows a premium and lesser correlation to the market
Sure, if you ignore historical costs and changing definitions of factors. Those are really big IF's to choose not to look at.

When factors were losing is was okay so say we found a smaller part of the world were factors still performed. Can't we use the same logic to say market beat factors somewhere and factor premiums are actually still negative relative to the market?

The changing factor definitions seems to be accompanied by very fluid logic where it would be impossible not to have factors outperforming.

The inability to be proven wrong doesn't make a strong case for factors. A good argument would be able to be proven incorrect or correct.
Last edited by abc132 on Mon Jan 15, 2024 4:27 pm, edited 2 times in total.
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Re: More Evidence Against Factor Investing

Post by McQ »

BetaTracker wrote: Mon Jan 15, 2024 1:04 pm New research by three professors seems to open a major hole in factor investing's reliability in explaining expected returns. The paper is here:
https://d1e00ek4ebabms.cloudfront.net/p ... 3d2475.pdf
It showed how the returns of several big factor drivers of investment returns could vary all over the place, and be highly dependent on what timeframe one measured. Isn't that what Bogle used to argue, too?
...
The FT article puts everything into a very understandable context, and draws from comments of other noted quant types. It's well worth a read:
https://www.ft.com/content/2e87e7f9-c2a ... pe=nongift
I've worked with the archived factor estimates that Ken French now posts on his website and can confirm that different revisions can produce different factor estimates, and these differences are noticeable. CRSP made major revisions to its data in 2005 and 2014; here is a chart showing how the 2022 (current) HML estimates differ from those in 2004 and 2013 (i.e., just before the revisions).

Image

But before running about yelling "The factors are falling! The factors are falling!" forum members comfortable with high academese will probably want to look at this paper by Jensen et al. published about the same time in the Journal of Finance (the #1 peer-reviewed publication in the finance sphere).

https://onlinelibrary.wiley.com/doi/ful ... jofi.13249
Is There a Replication Crisis in Finance?
THEIS INGERSLEV JENSEN, BRYAN KELLY, LASSE HEJE PEDERSEN
First published: 26 May 2023 https://doi.org/10.1111/jofi.13249

ABSTRACT
Several papers argue that financial economics faces a replication crisis because the majority of studies cannot be replicated or are the result of multiple testing of too many factors. We develop and estimate a Bayesian model of factor replication that leads to different conclusions. The majority of asset pricing factors (i) can be replicated; (ii) can be clustered into 13 themes, the majority of which are significant parts of the tangency portfolio; (iii) work out-of-sample in a new large data set covering 93 countries; and (iv) have evidence that is strengthened (not weakened) by the large number of observed factors.

Introduction

Several research fields face replication crises (or credibility crises), including medicine (Ioannidis (2005)), psychology (Nosek, Spies, and Motyl (2012)), management (Bettis (2012)), experimental economics (Maniadis, Tufano, and List (2017)), and now also financial economics. Challenges to the replicability of finance research take two basic forms:

1.
No internal validity. Most studies cannot be replicated with the same data (e.g., because of coding errors or faulty statistics) or are not robust in the sense that the main results cannot be replicated using slightly different methodologies and/or slightly different data. For example, Hou, Xue, and Zhang (2020) state that:

“Most anomalies fail to hold up to currently acceptable standards for empirical finance.”

2.
No external validity. Most studies may be robustly replicated, but are spurious and driven by “p-hacking,” that is, find significant results by testing multiple hypotheses without controlling the false discovery rate (FDR). Such spurious results are not expected to replicate in other samples or time periods, in part because the sheer number of factors is simply too large, and too fast growing, to be believable. For example, Cochrane (2011) asks for a consolidation of the “factor zoo,” and Harvey, Liu, and Zhu (2016) state that:

“most claimed research findings in financial economics are likely false.”

In this paper, we examine these two challenges both theoretically and empirically. We conclude that neither criticism is tenable. The majority of factors do replicate, do survive joint modeling of all factors, do hold up out-of-sample, are strengthened (not weakened) by the large number of observed factors, are further strengthened by global evidence, and the number of factors can be understood as multiple versions of a smaller number of themes.

[remainder of the paper is accessible at the link given, and the authors have made their data set publicly available.]
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Re: More Evidence Against Factor Investing

Post by DonIce »

The performance of the S&P500 is excellently explained by considering the performance of 500 individual factors. These 500 factors explain the performance so well that you can even throw away the "market beta" factor completely! I choose to invest in all 500 of these factors for the maximum diversification benefit.
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Re: More Evidence Against Factor Investing

Post by RationalWalk »

Speaking as a psychologist, I often submitted to the "Journal of Irreproducible Results." Finance and Economics have their own version, I guess.
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Re: More Evidence Against Factor Investing

Post by Logan Roy »

I swear we were having this same discussion many years ago – except, what we now call 'factors' were called 'stock screens', and academia wouldn't touch them with a barge pole.

You've got a Graham value screen, a Fisher quality screen, a simple small-cap screen .. And to be fair to all the active investors who used stock screens, I think they had a much better grip on how 'factors' functioned in the real world, and what tended to go wrong with them
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Re: More Evidence Against Factor Investing

Post by muffins14 »

nisiprius wrote: Mon Jan 15, 2024 2:22 pm
Nathan Drake wrote: Mon Jan 15, 2024 2:10 pm We have live funds that show a robust premium across geographies and time.

The last 4 years have certainly been great for factor enthusiasts
Have they? Could you please state a good, mainstream, typical factor portfolio, with tickers and percentages, that would have been approved by factor enthusiasts just before the start of 2020, and compare it with a Bogleheads three-fund using the same percentages for US stocks, international stocks, and bonds.

Here's what I get when I tried this exercise using the Bill Schultheis Coffee House portfolio, which is a simplified factor portfolio with restrained tilts.

Source

Image

It doesn't look to me as if the last four years have been particularly good for factor investing, but maybe I need to slot in AVUV or something to see it.
Isn’t it obvious if you look at something like FNDA vs VTI from 2019 to now that they did not have identical performance?

And also that one of them has nonzero factor loads and one of them does?

Factors explain variance, they don’t guarantee over performance
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Re: More Evidence Against Factor Investing

Post by muffins14 »

DonIce wrote: Mon Jan 15, 2024 4:31 pm The performance of the S&P500 is excellently explained by considering the performance of 500 individual factors. These 500 factors explain the performance so well that you can even throw away the "market beta" factor completely! I choose to invest in all 500 of these factors for the maximum diversification benefit.
I don’t think the threads needs trolling
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Re: More Evidence Against Factor Investing

Post by triz »

More evidence? Honestly not discouraging to hear for me, as I want *less* people in these funds. If factor investing was seen as the "obvious" play, then there wouldn't be any premium. The fact that a lot of people are skeptical and look at the last 10-15 years as proof that it is dead is why it works sporadically over long periods.

Personally I'd be more worried if I were holding funds that consistently won and had a strong past decade or so and I like to look forward not backward, and ultimately value as a concept is as evergreen as they come. I strongly believe humans are going to human and there will always be overreactions in the "loser" stocks and "winner" stocks. Professionals will not be able to hold on long enough because their clients are going to be clamoring for short term actions towards underperformance over even over a single year.
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Re: More Evidence Against Factor Investing

Post by the_wiki »

Growth just had a really good run so of course value investing must be dead.


Just like in 2009 everyone thought growth was dead and S&P 500 legendary run was history.
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Re: More Evidence Against Factor Investing

Post by nisiprius »

The paper in the original post, cited by BetaTracker,
and available more directly at SSRN isn't just more same-old same-old. It isn't about the behavior of factors and whether they can be expected to persist. It is a shot at the "integrity" of the Fama-French factor data itself.

I want to be careful not to go beyond the exact language they use, but in their own words
Our findings have significant implications for the integrity of finance research and underscore the importance of understanding the provenance of third-party data.
The specific finance research they are talking about is Fama and French, and, specifically, the data Ken French posts in his online data library. Their findings have "implications for the integrity" of this data.

The paper says that if you download what you would expect to be the same data, at different years, you get different data. McQ confirms this independently in this post, above.

The paper says, if I understand it correctly, that the methodology French uses has not been published, and that they have strong evidence that changes in the same factor values of the same assets for the same years are mostly the result of changes in that methodology, not revisions of the base data. In other words, they say
the changes appear to be the result of intentional modifications to the code.
The paper notes:
Taken together, these results indicate that the retroactive changes to the factors have led to an apparent improvement in the performance of the value factor. Consequently, a value-based investment strategy may appear more attractive using more recent vintages of French’s factors. Many asset managers employ such a strategy, including Dimensional Fund Advisors (DFA), which occasionally refers to French’s factor data in its publicly available marketing and educational materials.
Now, this doesn't mean that the three-factor model isn't valid. They say:
o be clear, nothing in this analysis speaks to the validity of the three- (or five-) factor model, only to this particular source of factor data.
Last edited by nisiprius on Mon Jan 15, 2024 7:39 pm, edited 2 times in total.
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Re: More Evidence Against Factor Investing

Post by snowday2022 »

Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
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Re: More Evidence Against Factor Investing

Post by Charles Joseph »

Here's what I don't understand. With all the fancy factor this and factor that, or momentum this or momentum that. Or (I love these from AQR) "Defensive Style", "Multi-Style"...

...Whatever fancy and complicated stuff gets made up, this fact remains: the aggregate returns of all investors in the market must by necessity equal the total returns of the market (thank you John Bogle, David Swensen, Warren Buffett, et al.). It cannot be any other way.

So why at the end of the day does anyone bother with this factor garbage investing? Now there may be a good answer to that question I'm not aware of. I mean, what do I know? But holding the total market at the lowest possible cost just seems to make the most sense.

EDIT: edited as above. Thank you to the fellow Boglehead for providing a lesson on etiquette.
Last edited by Charles Joseph on Mon Jan 15, 2024 8:26 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm

...Whatever fancy and complicated stuff gets made up, this fact remains: the aggregate returns of all investors in the market must by necessity equal the total returns of the market (thank you John Bogle, David Swensen, Warren Buffett, et al.). It cannot be any other way.
That’s not inconsistent with SCV having a higher return with more risk.
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Re: More Evidence Against Factor Investing

Post by Call_Me_Op »

Growth will sometimes zig when value zags. That is enough reason for me to own both in separate funds.
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Re: More Evidence Against Factor Investing

Post by Gaston »

Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm the aggregate returns of all investors in the market must by necessity equal the total returns of the market
This sounds like “Sharpe’s Arithmetic”, an argument put forward by Dr. William Sharpe some 30 years ago. It’s been some time since I read about Sharpe’s arithmetic, but as you say, Dr. Sharpe argued that the average return of all investors must equal the market return.

He went on to say that any tilt away from “total market” is an active bet that one set of stocks will do better than the market. He then pointed out the counter-party to any such active bet must be another active investor willing to make an equal and opposite counter bet.

If one accepts Sharpe’s arithmetic, the factor investor can outperform the market only to the cost of another active investor.

I recall that Dr. Sharpe’s article on this topic was short and easy to understand. No doubt it is available via a quick Google if you are interested in reading it.
Last edited by Gaston on Mon Jan 15, 2024 8:23 pm, edited 3 times in total.
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Re: More Evidence Against Factor Investing

Post by jjj_22 »

Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm So why at the end of the day does anyone bother with this factor [investing]?
Even if there were no factor premium (I'm not getting into that here), it's still possible that factors represent different sources of risk, and diversifying an equity portfolio across different sources of risk can lower volatility. During decumulation, getting the same or even modestly lower return with lower volatility increases the total amount of consumption the portfolio can support in the bad cases, because it alleviates some sequence of return risk. :beer
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Re: More Evidence Against Factor Investing

Post by Charles Joseph »

jjj_22 wrote: Mon Jan 15, 2024 8:05 pm
Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm So why at the end of the day does anyone bother with this factor [investing]?
Even if there were no factor premium (I'm not getting into that here), it's still possible that factors represent different sources of risk, and diversifying an equity portfolio across different sources of risk can lower volatility. During decumulation, getting the same or even modestly lower return with lower volatility increases the total amount of consumption the portfolio can support in the bad cases, because it alleviates some sequence of return risk. :beer
Okay, stay with me here if you will, cuz I'm kinda stooopid (seriously; I have only a very rudimentary knowledge of DIY investing that allows me to get by without generally making any serious mistakes - thank you Bogleheads).

Can't what you described above also be achieved by simply tweaking one's stock/bond allocation to manage SOR risk? Or is that oversimplifying?

PS: I edited my original post per your edit above. Most appropriate. Thank you.
Last edited by Charles Joseph on Mon Jan 15, 2024 8:27 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Charles Joseph »

Call_Me_Op wrote: Mon Jan 15, 2024 7:53 pm Growth will sometimes zig when value zags. That is enough reason for me to own both in separate funds.
But I own both in VTI, no? When one slides down, the other slides up, and vice versa. Right? Kind of a beautiful thing.
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Re: More Evidence Against Factor Investing

Post by exodusing »

snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
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Re: More Evidence Against Factor Investing

Post by km91 »

Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm But holding the total market at the lowest possible cost just seems to make the most sense.
Does it though? In any market other than stock market the strategy of buying the total market would make no sense. Do you buy regular, mid grade, and supreme at the gas station? Do you own a Tesla, Camry, Silverado, and Corolla in proportion to the total car market? If someone asks you for a recommendation for a product or consumer good do you reply with "all of them" or are there other "factors" that need to be considered?
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Re: More Evidence Against Factor Investing

Post by snowday2022 »

exodusing wrote: Mon Jan 15, 2024 8:28 pm
snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
Over short time frames, higher risk has translated into higher volatility. Over long time frames, it has not underperformed, and by most accounts has outperformed. If the total market folks think it no longer has a premium, do they think it no longer has added risk? Or does SCV confer added risk for no premium? If there’s no added risk anymore because there is no premium, then there should be no harm in tilting towards it.
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Re: More Evidence Against Factor Investing

Post by Charles Joseph »

km91 wrote: Mon Jan 15, 2024 8:30 pm
Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm But holding the total market at the lowest possible cost just seems to make the most sense.
Does it though? In any market other than stock market the strategy of buying the total market would make no sense. Do you buy regular, mid grade, and supreme at the gas station? Do you own a Tesla, Camry, Silverado, and Corolla in proportion to the total car market? If someone asks you for a recommendation for a product or consumer good do you reply with "all of them" or are there other "factors" that need to be considered?
I think I would answer this by referring to what Louis Brandeis called "the relentless rules of humble arithmetic", and thus by re-stating my original principle outlined by the multiple sources I cited above: "the aggregate returns of all investors in the market must by necessity equal the total returns of the market."

Again, it can't be any other way. It seems that any strategy which deviates from that would only work until it doesn't.
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Re: More Evidence Against Factor Investing

Post by Gaston »

km91 wrote: Mon Jan 15, 2024 8:30 pm
Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm But holding the total market at the lowest possible cost just seems to make the most sense.
Does it though?
Yes, it does. This is a cornerstone principle that most Bogleheads, I believe, will endorse. It makes sense because a) you are nearly certain to earn something very close to the return of the market, and b) you are likely to outperform 90%+ of all other investors over the long term.

This is not just academic theory (although it sprang from academia in the 1960s, or perhaps even earlier), it has been shown empirically to be the case for over four decades now. Note that this is not a statement based on backtests of data; it was and still is a forward-looking prediction. I can think of few other predictions in finance that have been so thoroughly and consistently confirmed.

If one wishes to tilt toward other investment strategies, that’s fine, but the evidence for the potential success of such strategies will be much weaker.
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Re: More Evidence Against Factor Investing

Post by Nathan Drake »

Gaston wrote: Mon Jan 15, 2024 8:46 pm
km91 wrote: Mon Jan 15, 2024 8:30 pm
Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm But holding the total market at the lowest possible cost just seems to make the most sense.
Does it though?
Yes, it does. This is a cornerstone principle that most Bogleheads, I believe, will endorse. It makes sense because a) you are nearly certain to earn something very close to the return of the market, and b) you are likely to outperform 90%+ of all other investors over the long term.

This is not just academic theory (although it sprang from academia in the 1960s, or perhaps even earlier), it has been shown empirically to be the case for over four decades now. Note that this is not a statement based on backtests of data; it was and still is a forward-looking prediction. I can think of few other predictions in finance that have been so thoroughly and consistently confirmed.

If one wishes to tilt toward other investment strategies, that’s fine, but the evidence for the potential success of such strategies will be much weaker.
The evidence for potential success is roughly the same rate as the market over bonds.

Investing in cap weighted funds is fine and probably the best default position, but there’s plenty of asset class types one could allocate to and have higher returns than the market, either due to illiquidity or increased risk.
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Re: More Evidence Against Factor Investing

Post by Northern Flicker »

nisiprius wrote: The size factor, discovered in 1981, is the granddaddy of all factors. Nobody in the factor crowd is willing to come right out and say that it doesn't exist and never did, but it sure ain't what it was.
I believe that Antonio Picca, who Vanguard hired to head up their factor fund strategies and products group, stated quite explicitly that there is no size factor, but rather a liquidity factor. This is not a majority viewpoint, but the contention would be that the size factor was a liquidity factor, and as small caps have become more liquid, the risk premium has diminished accordingly.

One of the factor funds Vanguard created was a liquidity factor fund. Per Vanguard's press release, it was difficult to explain what it tried to accomplish to advisors and investors, and was shut down and liquidated. Dr. Picca no longer works for Vanguard.
Last edited by Northern Flicker on Tue Jan 16, 2024 12:21 am, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by scout1 »

Pat Atkay (one of the authors in the OP) did a guest presentation at my megacorp bank in the middle of last year saying the fama french numbers were adjusted on multiple occasions to make them appear stronger.

One thing he said was that Ken French kept changing the numbers on his own website to make the data look better. The presentation caught a lot of the audience by surprise but I didn’t hear about it again till now on Bogleheads. I expect an efficient market for ideas will sort this all out.
Last edited by scout1 on Tue Jan 16, 2024 12:32 am, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by Northern Flicker »

There does not seem to be a consensus on the precise way to define a value factor.
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Re: More Evidence Against Factor Investing

Post by rushrocker »

Northern Flicker wrote: Tue Jan 16, 2024 12:18 am
nisiprius wrote: The size factor, discovered in 1981, is the granddaddy of all factors. Nobody in the factor crowd is willing to come right out and say that it doesn't exist and never did, but it sure ain't what it was.
I believe that Antonio Picca, who Vanguard hired to head up their factor fund strategies and products group, stated quite explicitly that there is no size factor, but rather a liquidity factor. This is not a majority viewpoint, but the contention would be that the size factor was a liquidity factor, and as small caps have become more liquid, the risk premium has diminished accordingly.

One of the factor funds Vanguard created was a liquidity factor fund. Per Vanguard's press release, it was difficult to explain what it tried to accomplish to advisors and investors, and was shut down and liquidated. Dr. Picca no longer works for Vanguard.
One thing I found interesting about the Dimensional Small Cap Value mutual fund, DFSVX, is that over its entire 30+ year history now (since 1993), its had almost exactly the same returns to its total performance contributed by the "small" factor, SmL, as it has from the "value" factor, HmL. Each factor contributing approximately 4% of the returns of DFSVX:

Image

https://www.portfoliovisualizer.com/fac ... bcEAJgechu.

Now if we change the start date to 1998, the introduction of the Vanguard Small Cap Value index (VISVX), you can see that both DFSVX and VISVX have outperformed the S&P 500. But less than 1% of the total contributions of all the factors (including market beta) of that return came from value, while nearly 10% of the return came from small size. This means it was completely meaningless that the fund had a value tilt, and very important that it had the small size tilt.

Image

https://www.portfoliovisualizer.com/fac ... 7vFgVZgwFY.

As someone with a small and value tilt, this is a tough pill to swallow for me, because supposedly the small factor premium doesn't exist, and yet in the last 25 year period, this small factor provided a massively higher return than the value factor to the DFSVX fund. People constantly reference this specific fund as proof of concept, always with start dates between 1993-2006ish and yet the real truth is that a factor that supposedly doesn't even provide a premium was one of the main drivers of returns for the fund.

Another way of looking at factors is this, it will give you diversification. You might win, or you might lose, during your given investment period, but your returns will differ from that of a total market fund.
Last edited by rushrocker on Tue Jan 16, 2024 1:57 pm, edited 1 time in total.
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Re: More Evidence Against Factor Investing

Post by muffins14 »

exodusing wrote: Mon Jan 15, 2024 8:28 pm
snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
You could say the same thing about stocks vs bonds
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Re: More Evidence Against Factor Investing

Post by exodusing »

snowday2022 wrote: Mon Jan 15, 2024 8:42 pm
exodusing wrote: Mon Jan 15, 2024 8:28 pm
snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
Over short time frames, higher risk has translated into higher volatility. Over long time frames, it has not underperformed, and by most accounts has outperformed. If the total market folks think it no longer has a premium, do they think it no longer has added risk? Or does SCV confer added risk for no premium? If there’s no added risk anymore because there is no premium, then there should be no harm in tilting towards it.
A SCV portfolio is not very diversified and risks that are diversifiable are not expected to be rewarded under standard investment theory.
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Re: More Evidence Against Factor Investing

Post by exodusing »

muffins14 wrote: Tue Jan 16, 2024 3:47 am
exodusing wrote: Mon Jan 15, 2024 8:28 pm
snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
You could say the same thing about stocks vs bonds
See, for example, viewtopic.php?t=421165
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Re: More Evidence Against Factor Investing

Post by muffins14 »

exodusing wrote: Tue Jan 16, 2024 5:40 am
snowday2022 wrote: Mon Jan 15, 2024 8:42 pm
exodusing wrote: Mon Jan 15, 2024 8:28 pm
snowday2022 wrote: Mon Jan 15, 2024 7:27 pm Does anybody think SCV will do WORSE than total market? And if the odds of that are low, over sufficiently long time frame, why not invest in the event that it outperforms?
The claimed rationale for SCV is higher expected return due to higher risk. If the odds of SCV doing worse over any given time frame (for example, a long one) are low, then it's hard to maintain that SCV has higher risk.
Over short time frames, higher risk has translated into higher volatility. Over long time frames, it has not underperformed, and by most accounts has outperformed. If the total market folks think it no longer has a premium, do they think it no longer has added risk? Or does SCV confer added risk for no premium? If there’s no added risk anymore because there is no premium, then there should be no harm in tilting towards it.
A SCV portfolio is not very diversified and risks that are diversifiable are not expected to be rewarded under standard investment theory.
What’s your evidence that a SCV portfolio is not very diversified? What is your definition of that word?
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Re: More Evidence Against Factor Investing

Post by Lastrun »

Gaston wrote: Mon Jan 15, 2024 8:00 pm
Charles Joseph wrote: Mon Jan 15, 2024 7:29 pm the aggregate returns of all investors in the market must by necessity equal the total returns of the market
This sounds like “Sharpe’s Arithmetic”, an argument put forward by Dr. William Sharpe some 30 years ago. It’s been some time since I read about Sharpe’s arithmetic, but as you say, Dr. Sharpe argued that the average return of all investors must equal the market return.

He went on to say that any tilt away from “total market” is an active bet that one set of stocks will do better than the market. He then pointed out the counter-party to any such active bet must be another active investor willing to make an equal and opposite counter bet.

If one accepts Sharpe’s arithmetic, the factor investor can outperform the market only to the cost of another active investor.

I recall that Dr. Sharpe’s article on this topic was short and easy to understand. No doubt it is available via a quick Google if you are interested in reading it.
Cochrane has made similar arguments, that IMHO, are more compelling to those perusing these factor threads. And they have always bothered me. Here are the contexts:

Quoting Cochrane from his appearance on the Rational Reminder Podcast https://rationalreminder.ca/podcast/169:
Yeah, which is, is this investment right for you? Now when the advisor says, "This is a great investment, everyone should buy it." Now we're back into magic alpha land. And a good question I suggested for when the investment advisor says, "Well, you really ought to be buying value stocks." You should ask, "Okay, who are you advising to buy growth stocks and short value stocks?"
Quoting Cochrane from his Multi-factor World article https://static1.squarespace.com/static/ ... 3Q99_4.pdf:
Bear in mind, however, that the average investor must hold the market portfolio. Thus, multiple factors and return predictability cannot have any portfolio implications for the average investor. In addition, for every investor who should follow a value strategy or time the market for the extra returns offered by those extra risks, there must be an investor who should follow the exact opposite advice. He should follow a growth strategy or sell stocks at the bottom and buy at the top, because he is unusually exposed to or averse to the risks of the value or market-timing strategies in his business or job.
Italics are the authors.

So I read this as the BH who is one of the founders of, and C-level at, Tinycorp, with options, RSUs, NQDC, etc. should seriously consider tilting away from small and value.

I just don't see a lot of discussion on this forum of this (theoretically perhaps, but practically with questioning OPs-no) and it seems the SOP of many (certainly not all) is some factor tilt.

Disclosure, I have a SCV tilt, and am empirically and behaviorally satisfied with it.
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