stlutz wrote:Betting only on small/value is not factor diversified.
This is a crucial premise in your argument, and I think it is critical to understand why a typical factor investor is not actually doing that, even if they put 100% of their stock allocation into a SV fund.
So if with that statement you meant to refer to a portfolio that had only small and value exposure and no Beta exposure, then sure--such a portfolio would be less diversified than it could be due to the lack of Beta exposure. And if, hypothetically, there was no return to small and value and only a return to Beta, such a portfolio would then get no return.
But holding 100% of your stocks in, say, a SV fund is not going to result in such a portfolio. For example, according to Portfolio Visualizer, DFA's small value fund has a Small loading of 0.79, Value of 0.65, AND a Beta loading of 1.02. IJS, a popular alternative for those without access to DFA, has a Small of 0.80, Value of 0.49, AND Beta of 0.95. VBR, the Vanguard SV option, is 0.57 Small, 0.38 Value, AND 1.03 Beta.
You might note the Beta exposure was always close to 1--that is because it would be very difficult to put together a large, diversified index of stocks that did NOT have a Beta close to 1. So if you just select for characteristics like small and value, odds are you will in fact end up with a Beta close to 1 as well.
Indeed, that's a large part of why Fama-French defined their small and value factors in terms of combined long-short portfolios. That's basically the only practical way of defining portfolios where you isolate small or value from Beta, with the shorts serving to cancel out the Beta of the longs.
So people who invest only long in U.S. SV very much have not given up on betting on Beta too. To actually get rid of that Beta, they'd have to go short in U.S. LG with half their U.S. stock portfolio . . . and I am not aware of anyone doing that.
OK, so understanding that, imagine you have 100% in one of those small value funds, and it ends up there are no returns to small and value but there is a return to Beta. Do you have no returns? Nope. You only have Beta returns, but you do in fact still have those. And in fact you probably have right around as much of them as a TSM investor (except to the extent you held more fixed and therefore lowered your overall stock percentage).
That's why someone with 100% long positions in a SV fund is still factor-diversified. Again, to actually eliminate that Beta exposure, they'd have to also short LG stocks, and who does that?