Larry Swedroe: What Makes Factors Endure

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Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Mon Jun 11, 2018 8:54 am

http://www.etf.com/sections/index-inves ... nopaging=1

Good introduction to why there is good rationale to expect factors to persist in the future. It centers on Larry’s 5 criteria for a factor: persistent, pervasive, robust, intuitive, investable. Larry displays a chart showing the likelihood of the different factors providing a negative premium over different time frames. Value is about as persistent as market beta, and momentum is even more persistent than market beta. What he doesn’t show in this short essay is the power of diversifying across factors. Need to see Chapter 9 of his factor book for that.
Larry comments that he has more faith in risk based explanations for factors, but the data for behavioral ones is so strong. Moreover, limits to arbitrage decrease the likelihood of factor premia being erased. All the factors can underperform for long periods, so need strong belief to stick to them with discipline; more reason to diversify across them.
One can apply Larry’s 5 criteria when considering any new potential source of return to a portfolio. What a potential portfolio addition contributes depends on expected return, volatility, correlations, and of course costs.

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Re: Larry Swedroe: What Makes Factors Endure

Post by cfs » Mon Jun 11, 2018 2:23 pm

Thank you Mister Dave for the link to another good article by Mister Larry.

Good luck, y gracias por leer ~cfs~
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Re: Larry Swedroe: What Makes Factors Endure

Post by golfCaddy » Mon Jun 11, 2018 3:33 pm

Some of the same problems are in this piece as in other pieces. What's the intuitive theory, either behavioral or risk-based, for the quality/profitability factors? On momentum, what's the intuitive explanation for excluding the first month? What's the intuitive explanation for 12-month momentum instead of 24-month momentum? On small, why is the performance almost entirely an artifact of the January effect?

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Re: Larry Swedroe: What Makes Factors Endure

Post by Taylor Larimore » Mon Jun 11, 2018 7:24 pm

Bogleheads:

Alternate ideas are good, but we must never forget the fundamental purpose of this forum: "Investing advice inspired by John Bogle."

This is what Mr. Bogle thinks about "factors" (also known as "smart beta"):
“Sometimes [investors] will pick the right factor, sometimes they will pick the wrong factor, but to the extent that investors pick the hot factor, they almost assuredly will be wrong.”

On smart beta investing in general:

Bogle: “I believe that smart beta is stupid.”
Jack Bogle Says Smart Beta Funds Are Stupid.
Jack Bogle, "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk." -- "The odds of outpacing an all-market index fund are, well, terrible."
Best wishes.
Taylor
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Re: Larry Swedroe: What Makes Factors Endure

Post by digarei » Mon Jun 11, 2018 7:59 pm

Taylor Larimore wrote:
Mon Jun 11, 2018 7:24 pm
John C Bogle wrote:
“I believe that smart beta is stupid.”

Jack is always good for a pithy quote! He has elaborated on this topic in the past but I like the longer explanation given by former Vanguard Chief Investment Officer Gus Sauter , who rather handily deconstructs Smart Beta in this 2016 presentation:

Gus Sauter: What really is smart β, September 30, 2016 (Presentation Slides)

Gus Sauter: What really is smart β, September 30, 2016 (Presentation Audio)

...
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Re: Larry Swedroe: What Makes Factors Endure

Post by triceratop » Mon Jun 11, 2018 8:10 pm

digarei wrote:
Mon Jun 11, 2018 7:59 pm
Taylor Larimore wrote:
Mon Jun 11, 2018 7:24 pm
John C Bogle wrote:
“I believe that smart beta is stupid.”

Jack is always good for a pithy quote! He has elaborated on this topic in the past but I like the longer explanation given by former Vanguard Chief Investment Officer Gus Sauter , who rather handily deconstructs Smart Beta in this 2016 presentation:

Gus Sauter: What really is smart β, September 30, 2016 (Presentation Slides)

Gus Sauter: What really is smart β, September 30, 2016 (Presentation Audio)

...
Notably, the linked presentation's purpose is to discredit the idea that fundamental indices are a superior way to obtain exposure to factors as compared to capitalization-weighted style-focused indices. I'd be careful about associating Sauter's views with Bogle's because they don't appear to be the same (at least, the linked presentation doesn't substantiate such a view).

It doesn't discredit factor-based investing in general, and especially not by way of using cap-weighted index funds to do so. In this respect Taylor is mistaken to say that factors are "also known as 'smart beta'". No, and Sauter's presentation shows the difference; Sauter's conclusion:
Gus Sauter wrote:If you want to make a factor bet, make the factor bet transparent, then take it in the most cost and tax-efficient fashion.
The other quote Taylor employs:
“Sometimes [investors] will pick the right factor, sometimes they will pick the wrong factor, but to the extent that investors pick the hot factor, they almost assuredly will be wrong.”
This is not an argument against factor investing, but against chasing whatever style is outperforming. The same argument applies to chasing hot mutual funds, sectors, and stocks.
"To play the stock market is to play musical chairs under the chord progression of a bid-ask spread."

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Re: Larry Swedroe: What Makes Factors Endure

Post by Ron Scott » Mon Jun 11, 2018 8:26 pm

I think "what makes factors endure" is the amount of money they earn for those who use them to market their services.

If it looks and smells like an actively managed pile, don't step in it.
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Re: Larry Swedroe: What Makes Factors Endure

Post by larryswedroe » Mon Jun 11, 2018 8:28 pm

Taylor
Just to clarify, factor investing has NOTHING to do with "smart beta" which is almost 100% marketing hype as by definition beta is just exposure to a factor, how much loading a fund has on a factor. Thus, it cannot be smart or dumb, it just is.
On other hand there is a bit of truth to the term, so dumb beta is like forced trading by indices, like the Russell 2000 and the front running it experienced. While smart beta would be patient trading, and excluding lottery stocks (based on the research).
Best wishes
Larry

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Re: Larry Swedroe: What Makes Factors Endure

Post by stlutz » Mon Jun 11, 2018 8:40 pm

Dave,

I'm wondering whether you think that a compelling, rational reason for most investors to take the other side of the trade should be such a criteria?

e.g.

"Everybody knows stocks are highly likely to outpeform bonds. But, most of the money should still prefer bonds because ___________"

"Everybody knows high momentum stocks will outpeform low momentum ones. But most of the money should prefer low momentum stocks because _______"

"Everybody knows value outperforms growth. But most of the money should prefer growth because ________"

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Re: Larry Swedroe: What Makes Factors Endure

Post by Taylor Larimore » Mon Jun 11, 2018 8:46 pm

larryswedroe wrote:
Mon Jun 11, 2018 8:28 pm
Taylor
Just to clarify, factor investing has NOTHING to do with "smart beta" which is almost 100% marketing hype as by definition beta is just exposure to a factor, how much loading a fund has on a factor. Thus, it cannot be smart or dumb, it just is.
On other hand there is a bit of truth to the term, so dumb beta is like forced trading by indices, like the Russell 2000 and the front running it experienced. While smart beta would be patient trading, and excluding lottery stocks (based on the research).
Best wishes
Larry
Larry:
Investopedia: Smart beta emphasizes capturing investment factors or market inefficiencies in a rules-based and transparent way.
Best wishes.
Taylor
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Re: Larry Swedroe: What Makes Factors Endure

Post by nisiprius » Mon Jun 11, 2018 8:47 pm

triceratop wrote:
Mon Jun 11, 2018 8:10 pm
...Taylor is mistaken to say that factors are "also known as 'smart beta'"...
Definitions are slippery and elusive. "Smart beta" is even more slippery and elusive than many.

I do not believe that Taylor is mistaken.

Investopedia quotes Andrew Ang, of Blackrock's Factor Based Strategy group, as saying:
Factors are the language of investing that everyone should be speaking. Smart Beta is the vehicle to deliver factor investing."
CNBC says
While definitions of these funds abound, as the name implies, they aim to beat the market (beta), either with better performance or better management of risks. They try to do that by tracking an index weighted according to factors other than market capitalization, such as dividend-paying policies, fundamental strength, value, momentum or low volatility.
iShares describes its SIZE, MTUM, VLUE, and QUAL ETFs as "smart beta" products.

Image

Oppenheimer Funds similarly says that its single-factor ETFs--specifically

OMOM Oppenheimer Russell 1000 Momentum Factor ETF
OVLU Oppenheimer Russell 1000 Value Factor ETF
OVOL Oppenheimer Russell 1000 Low Volatility Factor ETF
OSIZ Oppenheimer Russell 1000 Size Factor ETF
OQAL Oppenheimer Russell 1000 Quality Factor ETF
OYLD Oppenheimer Russell 1000 Yield Factor ETF

--are "smart beta" products:

Image

I believe it is accurate to say that in today's parlance, factor investing is considered to be "smart beta."
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Re: Larry Swedroe: What Makes Factors Endure

Post by triceratop » Mon Jun 11, 2018 9:00 pm

@nisi: fair enough, but in context I did say "In this respect" -- i.e. with respect to Sauter's presentation. If one takes your conclusion that they are wholly the same then Sauter's presentation is internally-inconsistent. I think something more subtle is afoot than can be demonstrated by linking to marketing materials.

My overall comment had to do with the fact that digarei linked to a study explicitly disentangling smart beta from factor-based investing yet Taylor's post treated smart beta the same as the topic of this thread (factors). That is, Sauter's point was that there is nothing smart about smart beta products like fundamental indices than can be obtained by factor exposure through cap-weighted index funds, often at lower overall cost.
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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Mon Jun 11, 2018 10:41 pm

stlutz wrote:
Mon Jun 11, 2018 8:40 pm
Dave,

I'm wondering whether you think that a compelling, rational reason for most investors to take the other side of the trade should be such a criteria?

e.g.

"Everybody knows stocks are highly likely to outpeform bonds. But, most of the money should still prefer bonds because ___________"

"Everybody knows high momentum stocks will outpeform low momentum ones. But most of the money should prefer low momentum stocks because _______"

"Everybody knows value outperforms growth. But most of the money should prefer growth because ________"
I thing the question about who is on the other side of the trade is an important one. Small stocks are riskier. Value stocks are riskier and value stocks do especially poorly in bad economic times. So an investor who wants a less risky stock with a commensurate lower expected return would be acting rationally to opt for large growth. This would be especially true if he personally couldn’t afford for his financial assets to crash at the same time he might lose his job or his business struggle.
Now investing is a very human endeavor. And we behave very differently from homo economicus. Instead there is a very human tendency to behave as homo gamblicus or homo microsofticus. Humans have a tendency (perhaps whether it’s rational or not can be argued) to overpay for growth. In the small growth realm they willingly overpay for small growth stocks or IPO’s with lottery like expected returns: they accept a lower mean expected return as a trade off for the unlikely possibility of a huge return. Even a sophisticated institutional investor who recognizes overpriced growth stocks may not be able to capitalize on the mispricing even though he’d really like to. It’s easy to go long a stock, but much more difficult to short it. The limits to arbitrage include the costs of borrowing, the risk of unlimited losses, institutional mandates that might preclude shorting.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by 2pedals » Mon Jun 11, 2018 10:55 pm

Is it fair to say that factor investing is a "smart" beta strategy? Is factor investing an investment vehicle (fund/ETF) that passes the "smart" beta strategy to the holder?

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Re: Larry Swedroe: What Makes Factors Endure

Post by stlutz » Mon Jun 11, 2018 11:23 pm

Small stocks are riskier.
How so? Do you really think that holding thousands of smallcap stocks is more risky than only owning only AAPL, MSFT, AMZN, and FB? Both portfolios represent 10% of the market. The "risk" from smallcap investing comes from concentrating in one small section of the market, not the stocks themselves. What if we split the market into a large half and small half, which is about 50 stocks versus all the rest. Which is riskier?
Value stocks are riskier and value stocks do especially poorly in bad economic times. So an investor who wants a less risky stock with a commensurate lower expected return would be acting rationally to opt for large growth. This would be especially true if he personally couldn’t afford for his financial assets to crash at the same time he might lose his job or his business struggle.
The historical value premium is larger in down market years than it has been in up market years. If value stocks are going to plummet much more than growth stocks in future bear markets, then the return premium to value stocks is gone.

If a person can't afford for his financial assets to crash when the economy goes down, aren't bonds a better bet than growth stocks? Growth stocks aren't exactly a refuge in bad times. Vanguard Growth Index fund was down 38% in 2008. Value index fund was down 36%. Where is the shelter that growth supposedly offers? Low volatility stocks--maybe. Growth? Nope.

Even more generally, growth has been more volatile than value, not less. Growth looks more risky to me based on the historical data. (https://www.portfoliovisualizer.com/bac ... rowth1=100)

I guess I would be more persuaded that you really believe what you're saying if I saw large cap growth stocks recommended more frequently on this forum. :happy We recommend that people bump up their bond allocations all of the time despite the fact that the overwhelming majority of us think that stocks will beat bonds over the long term. If concentrating only in large cap growth is such a rational choice for lots of people, why isn't it recommended frequently by the factor folks?
Humans have a tendency (perhaps whether it’s rational or not can be argued) to overpay for growth.


As some of the other posts have highlighted, there is a lot of marketing muscle behind small/value tilting now. "Smart beta", "Factor funds" etc. are in in the end mostly just tiling to value and small stocks.

It's true that in the past that investors have often overpaid for growth. Isn't all of factor/smart beta stuff just correcting those pricing errors such that they won't exist in the future?

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Re: Larry Swedroe: What Makes Factors Endure

Post by printer » Tue Jun 12, 2018 4:02 am

Nice article.

I'm a big fan of having objective criteria to define factors. I think what has been done here (a while back, at least as far back as one of Larry's books) to define criteria is really valuable. I'm also a fan of being able to debate and refine the criteria - that is a key part of the scientific method.

One thought: it's not clear to me that that investability should be required in order for something to be a factor. Imagine a factor-like entity that is not investable. First, there may be value in identifying this entity and using it to draw conclusions and understand securities behavior, even if the entity isn't investable. Second, investability could be transient. What is investable today may not be investable tomorrow, and vice versa. Third, investability could depend very much on specific mechanisms that may or may not be available in a given market for a given security, arbitrary legal choices, etc. In short, maybe investability is too fragile to use as a factor criterion. It certainly could be used as a criterion for whether the factor is investable in a particular circumstance. Larry?

Another observation: I think it is worth knowing that a correct intuitive explanation for a particular factory-like entity can, in principle, become incorrect. Things change. For example, there could be a (human) behavioral explanation for a particular factor - call it "Factor Z" - but it might happen in the future that humans are not making the investment decisions that determine whether Factor Z is present.

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Re: Larry Swedroe: What Makes Factors Endure

Post by larryswedroe » Tue Jun 12, 2018 7:34 am

Taylor
And you accept investopedia as the finance world's dictionary? No finance professor would even define it that way it's just media and marketing hype not a finance definition. Beta is defined in finance as exposure to a factor, which by definition cannot be smart or dumb, it just is. So you can have beta on market, size, value, momentum, etc. What you are quoting is just marketing, not finance.


Best wishes
Larry

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Tue Jun 12, 2018 9:05 am

printer wrote:
Tue Jun 12, 2018 4:02 am
One thought: it's not clear to me that that investability should be required in order for something to be a factor. Imagine a factor-like entity that is not investable.
Actually, I think any valid factor pretty much has to be investable by definition.

Factors explain the cross-section of stock returns (or other assets, but for now let's stick to stocks). That means that factors explain why, over a certain period of time, one group of stocks performed differently from some other group of stocks.

Thus, by definition, for any valid style or risk factor there must be some stocks that have a positive loading on (or exposure to) the factor while some other stocks have a negative loading on that same factor. We can only observe factors that produce differential market returns, which means the assets must be tradeable.

It's true we can't DIRECTLY invest in size, value, quality, or momentum but I'd say the factors themselves must still be investable. You can do this by owning more of the stocks with positive loading and less of the ones with negative loading. Or, if you have ready access to leverage, having a long position in one group and a short position in the other group.
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Re: Larry Swedroe: What Makes Factors Endure

Post by matjen » Tue Jun 12, 2018 9:10 am

triceratop wrote:
Mon Jun 11, 2018 9:00 pm
@nisi: fair enough, but in context I did say "In this respect" -- i.e. with respect to Sauter's presentation. If one takes your conclusion that they are wholly the same then Sauter's presentation is internally-inconsistent. I think something more subtle is afoot than can be demonstrated by linking to marketing materials.

My overall comment had to do with the fact that digarei linked to a study explicitly disentangling smart beta from factor-based investing yet Taylor's post treated smart beta the same as the topic of this thread (factors). That is, Sauter's point was that there is nothing smart about smart beta products like fundamental indices than can be obtained by factor exposure through cap-weighted index funds, often at lower overall cost.
+1 Well stated Triceratop. :beer
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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Tue Jun 12, 2018 9:11 am

St Lutz,
Yes I do think small stocks are riskier than big stocks. Who would you rather lend money to, a huge multinational company or a smaller local or regional company? Who would you charge the higher interest rate? The cost of capital for a company equals the expected return for the company’s stock. I wouldn’t expect grouping all the small companies together doesn’t change their average cost of capital.
Can’t give you much insight into the growth/value thing. I’ve simply read that value risk is specifically associated with doing badly in bad times. It intuitively makes sense to me as well. Companies that are highly leveraged and have volatile earnings would seem especially susceptible to me. I think growth stocks are subject to a different kind of risk, I think of it as bubble risk. In good times investors get overly optimistic about earnings growth, project it way out in the future, then stock takes itmon the chin when the perfect expectations for the future are not met.
YOU DO SEE LARGE CAP GROWTH RECOMMENDED ALL THE TIME on this forum. TSM and S&P 500 are dominated by large cap growth so much that they are effectively large cap growth funds. The factor folks believe they have plenty of large cap growth already in their core or TSM funds; they are trying to diversify away from that bias already in their portfolios.
I believe that despite the apparent popularity of value now, the actual growth-value spreads have not really changed. If value has been over grazed, we’d expect valuations to narrow.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Tue Jun 12, 2018 9:41 am

Taylor Larimore wrote:
Mon Jun 11, 2018 7:24 pm
Bogle: “I believe that smart beta is stupid.”

Jack Bogle Says Smart Beta Funds Are Stupid.
Jack Bogle, "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk." -- "The odds of outpacing an all-market index fund are, well, terrible."
"Smart Beta" might be a stupid name, but it's worth pointing out that Jack Bogle introduced some of the very first "Smart Beta" mutual funds to the investment marketplace.

Vanguard Value Index (VIVAX), Vanguard Small Cap Index (NAESX), Vanguard Growth Index (VIGRX), and Vanguard Extended Market Index (VEXMX) were all introduced by Vanguard while Bogle was CEO. All of these would fit squarely within any reasonable modern definition of "smart beta", even if they are relatively blunt instruments by today's standards.
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Re: Larry Swedroe: What Makes Factors Endure

Post by abuss368 » Tue Jun 12, 2018 6:22 pm

Taylor Larimore wrote:
Mon Jun 11, 2018 7:24 pm
Bogleheads:

Alternate ideas are good, but we must never forget the fundamental purpose of this forum: "Investing advice inspired by John Bogle."

This is what Mr. Bogle thinks about "factors" (also known as "smart beta"):
“Sometimes [investors] will pick the right factor, sometimes they will pick the wrong factor, but to the extent that investors pick the hot factor, they almost assuredly will be wrong.”

On smart beta investing in general:

Bogle: “I believe that smart beta is stupid.”
Jack Bogle Says Smart Beta Funds Are Stupid.
Jack Bogle, "The beauty of owning the market is that you eliminate individual stock risk, you eliminate market sector risk, and you eliminate manager risk." -- "The odds of outpacing an all-market index fund are, well, terrible."
Best wishes.
Taylor
Hi Taylor -

Thank you for the wise advice from Mr. Bogle. Investors would be smart to follow his lead!

Best.
John C. Bogle: "You simply do not need to put your money into 8 different mutual funds!" | | Disclosure: Three Fund Portfolio + U.S. & International REITs

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Re: Larry Swedroe: What Makes Factors Endure

Post by stlutz » Tue Jun 12, 2018 7:11 pm

Thanks for the reply, Dave.
Yes I do think small stocks are riskier than big stocks. Who would you rather lend money to, a huge multinational company or a smaller local or regional company? Who would you charge the higher interest rate?
This isn't really what I asked. Of course investing in a single smallcap company is is riskier than investing in a single large cap company. Since you didn't like my comparison of the entire smallcap universe vs. 4 large cap stocks, let's try a hypothetical instead.

Suppose you want to invest in 100 oil wells. You can do it through one large company that owns 100 wells. Or, I can invest in ten small companies that own 10 wells each. Which option do you consider to be riskier? Which should require the larger capital outlay from me (or would they be the same)?
Companies that are highly leveraged and have volatile earnings would seem especially susceptible to me.
.

I'm not aware of anyone who has claimed that there is a leverage factor or a volatile earnings factor. Do you think that a backtest specifically of companies with volatile earnings will show outperformance (and thus possibly a risk premium) or underperformance? Perhaps somebody can link to a study with such a test?
YOU DO SEE LARGE CAP GROWTH RECOMMENDED ALL THE TIME on this forum. TSM and S&P 500 are dominated by large cap growth so much that they are effectively large cap growth funds.
We seem to have a fundamentally different understandings of how asset pricing works, as it sounds to me like you're saying the equivalent of, "They sky is green and the ocean is orange". :happy

It's generally understood that an investor who wants to express no opinion of how stocks are priced relative to one another should by the total market. If I buy a total market fund I'm driving the price of all of the stocks up by a very small amount, but my impact is the same across all of them--Exxon would go up by .0001% as would Wells Fargo and Facebook. You want to call no opinion "growth". Fine.

In order for one set of stocks, let's call them "stlutz stocks", is going to outperform, they need to be priced lower than they will be in the future relative to the market. In order for that to happen, investors need to currently be shying away from these stlutz stocks. Taking a neutral, total market position doesn't help us out here. I need investors who are actively eschewing them or even shorting them.

Now, investors might avoid stlutz stocks because they are dumb. (Who would not want to own such stocks?!). But if one is to argue that stlutz stocks should rationally be priced for outperformance, there needs to be a logical, compelling reason to steer clear.

The total market investor does not take a negative position on stlutz stocks. They also do not take a negative position on value stocks or growth stocks--and that's allowing you to define "value" and "growth" however you want to! The total market investor is simply choosing not to have an opinion.

I'm asking--who are the investors who should wisely be expressing an opinion that value stocks are undesirable for them? That is, that they should seek a portfolio with negative value loading? I'm sorry, I've never seen a recommendation on this forum to prefer, say, invest only in VG Large Cap Growth Index and avoid Total Market Index. Perhaps it has happened, but it would be like looking for needle in a haystack.

Absent such logic that makes sense to most anyone, I don't see how you can have risk premium for such stocks, whether they be "value" stocks or "stlutz" stocks.

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Re: Larry Swedroe: What Makes Factors Endure

Post by grabiner » Tue Jun 12, 2018 7:26 pm

vineviz wrote:
Tue Jun 12, 2018 9:05 am
printer wrote:
Tue Jun 12, 2018 4:02 am
One thought: it's not clear to me that that investability should be required in order for something to be a factor. Imagine a factor-like entity that is not investable.
Actually, I think any valid factor pretty much has to be investable by definition.
Investability doesn't mean that it is possible to invest in the factor, but that it is possible to invest in the factor without losing the benefit. If you invest in investments which have factor X, you must buy investments which become X, and sell investments which lose X, and reinvest dividends (and for bond investors, proceeds from called or maturing bonds) in investments which have X. When you do this, you will lose the spread on your trades, and that might reduce the returns from factor X.
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Re: Larry Swedroe: What Makes Factors Endure

Post by david1082b » Tue Jun 12, 2018 7:35 pm

Random Walker wrote:
Tue Jun 12, 2018 9:11 am
TSM and S&P 500 are dominated by large cap growth so much that they are effectively large cap growth funds.
Total Stock Market is still inside the large blend box, though there is a slight bias to large growth according to M* http://portfolios.morningstar.com/fund/ ... ture=en-US

Vanguard Growth Index is very much in the growth box: http://portfolios.morningstar.com/fund/ ... ture=en-US

So I wouldn't say that Total Stock Market is effectively a large growth fund. S&P 500 fund is also in the blend box http://portfolios.morningstar.com/fund/ ... ture=en-US

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Tue Jun 12, 2018 8:26 pm

grabiner wrote:
Tue Jun 12, 2018 7:26 pm
Investability doesn't mean that it is possible to invest in the factor, but that it is possible to invest in the factor without losing the benefit. If you invest in investments which have factor X, you must buy investments which become X, and sell investments which lose X, and reinvest dividends (and for bond investors, proceeds from called or maturing bonds) in investments which have X. When you do this, you will lose the spread on your trades, and that might reduce the returns from factor X.
You're talking about expenses, and I agree that it goes without saying that (as investors) we should only pay significant attention to factors that can be invested in profitably.
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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Tue Jun 12, 2018 9:19 pm

stlutz wrote:
Tue Jun 12, 2018 7:11 pm
Thanks for the reply, Dave.
Yes I do think small stocks are riskier than big stocks. Who would you rather lend money to, a huge multinational company or a smaller local or regional company? Who would you charge the higher interest rate?
This isn't really what I asked. Of course investing in a single smallcap company is is riskier than investing in a single large cap company. Since you didn't like my comparison of the entire smallcap universe vs. 4 large cap stocks, let's try a hypothetical instead.

Suppose you want to invest in 100 oil wells. You can do it through one large company that owns 100 wells. Or, I can invest in ten small companies that own 10 wells each. Which option do you consider to be riskier? Which should require the larger capital outlay from me (or would they be the same)?
Companies that are highly leveraged and have volatile earnings would seem especially susceptible to me.
.

I'm not aware of anyone who has claimed that there is a leverage factor or a volatile earnings factor. Do you think that a backtest specifically of companies with volatile earnings will show outperformance (and thus possibly a risk premium) or underperformance? Perhaps somebody can link to a study with such a test?
YOU DO SEE LARGE CAP GROWTH RECOMMENDED ALL THE TIME on this forum. TSM and S&P 500 are dominated by large cap growth so much that they are effectively large cap growth funds.
We seem to have a fundamentally different understandings of how asset pricing works, as it sounds to me like you're saying the equivalent of, "They sky is green and the ocean is orange". :happy

It's generally understood that an investor who wants to express no opinion of how stocks are priced relative to one another should by the total market. If I buy a total market fund I'm driving the price of all of the stocks up by a very small amount, but my impact is the same across all of them--Exxon would go up by .0001% as would Wells Fargo and Facebook. You want to call no opinion "growth". Fine.

In order for one set of stocks, let's call them "stlutz stocks", is going to outperform, they need to be priced lower than they will be in the future relative to the market. In order for that to happen, investors need to currently be shying away from these stlutz stocks. Taking a neutral, total market position doesn't help us out here. I need investors who are actively eschewing them or even shorting them.

Now, investors might avoid stlutz stocks because they are dumb. (Who would not want to own such stocks?!). But if one is to argue that stlutz stocks should rationally be priced for outperformance, there needs to be a logical, compelling reason to steer clear.

The total market investor does not take a negative position on stlutz stocks. They also do not take a negative position on value stocks or growth stocks--and that's allowing you to define "value" and "growth" however you want to! The total market investor is simply choosing not to have an opinion.

I'm asking--who are the investors who should wisely be expressing an opinion that value stocks are undesirable for them? That is, that they should seek a portfolio with negative value loading? I'm sorry, I've never seen a recommendation on this forum to prefer, say, invest only in VG Large Cap Growth Index and avoid Total Market Index. Perhaps it has happened, but it would be like looking for needle in a haystack.

Absent such logic that makes sense to most anyone, I don't see how you can have risk premium for such stocks, whether they be "value" stocks or "stlutz" stocks.
St Lutz,
First, let me recommend Larry’s factor book for the data supporting the risk stories behind size and value. Now
Now let me take a crack at some of your thoughts. I’d choose the single company with 100 wells because it sounds less risky to me.
Leverage and volatile earnings are characteristics of value companies. They are felt to be the risk stories behind the value factor.
Yes I agree with you that a TSM investor is expressing no preference for any factor, sector, style, etc, except for the market factor. But it is the nature of market cap weighting that makes TSM and S&P 500 correlate so highly with large cap growth. Separate from that issue, an investor could rationally intentionally display a preference for large cap growth if he wants equities that are safer with lower expected return.
I don’t think we have different views of asset pricing. Mine is pretty simple. The market prices risk. Riskier assets have lower prices and this higher expected returns. I think many people are avoiding value companies. Fund managers frequently feel pressured to have the hot popular stocks in their portfolios: Amazon, Netflix, Facebook, etc. No one ever complains that their manager failed to have United Janitorial Supplies or Acme Ball Bearings in their portfolio.
I believe that Fama himself has said something to the effect that the TSM is always efficient. Tilting away from it is about preferences. And it can be rational for someone to tilt to safer lower return growth. The reason we don’t talk about it here is that there is so much of it already in Core and TSM portfolios. Take a look at Larry’s Factor Book. I’m going to reread it as well.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by triceratop » Tue Jun 12, 2018 9:33 pm

stlutz wrote:I'm sorry, I've never seen a recommendation on this forum to prefer, say, invest only in VG Large Cap Growth Index and avoid Total Market Index.
You're right, this is rare. I think I've seen it in the context of someone whose employment lies in an area which is positively correlated with value (bankruptcy law? M&A?). I think that's the prototypical example.
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Re: Larry Swedroe: What Makes Factors Endure

Post by larryswedroe » Wed Jun 13, 2018 7:58 am

To be helpful and address STLUTZ comment< one of the MANY risk based explanations for value is that a common trait of value companies is that they have more volatile earnings. On top of that they tend to also have more operating (more irreversible capital) and more financial leverage. Now combine those three characteristics and anyone with any knowledge of finance would say that companies with those characteristics are more risky, and that is why they have higher costs of capital (trade at lower P/Es and tend to have higher borrowing costs.

Note I had posted this information MANY times on this site, and it's been in several of my books.

And you can find the summary of the risk based explanations of the size and value premiums in the factor book.

And I would add that the comparison of one large growth stock versus many small stocks is a totally bogus analogy and should be ignored, it's just a phony trap because it ignores the idiosyncratic risks of the single large company or the few. The right question is which is riskier small stocks or large stocks (as an asset class). Clearly diversification reduces the idiosyncratic risks so that analogy is just a bad one.
Larry

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Re: Larry Swedroe: What Makes Factors Endure

Post by nedsaid » Wed Jun 13, 2018 8:13 am

A counter argument to Larry though I think we mostly agree here. Value stocks tend to have more fundamental risk (higher leverage, more volatile earnings) but I would argue that they have less pricing risk. That is, Value stocks have lower expectations built into them than Growth stocks. We have seen Growth stocks priced to perfection that saw disappointing performance afterwards. General Electric and Pfizer are two textbook examples of this, treated with nothing but love during the 1990's by the markets, but whose earnings performance just couldn't keep up with sky-high expectations thereafter. These two stocks are among my "four horsemen of underperformance" that I still own.

What I will say to support Larry's thesis is that times of crisis is where the fundamental risk shows up as you see a flight to quality during these times. This is where excess volatility in Value stocks show up. It seems just from eyeballing that Value is less volatile than Growth during more normal times.

This is a way of saying that there is a large behavioral explanation for this too. Investors and Wall Street tend to follow and to love the large Growth stocks. It is a matter of expectations, low expectations are easier to beat than higher expectations. To put it in Buffett terms, it is the old greed and fear.
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Re: Larry Swedroe: What Makes Factors Endure

Post by indexonlyplease » Wed Jun 13, 2018 9:27 am

Well I would say most of this is over most of our heads. Eventhough I read the books I still have a hard time understanding. So, if I own the 3 fund (which I do) I have bought into the belief that Total Market is the way to go for me. And I believe in Market Cap. Investing.


So does this just tell me I am willing to take what the market will give me?? I may get lucky by some other investing or tilting on some funds. But is my simple investing mind ok with what the market will give me??

I sure hope so because I decided 3 years ago to head this way. Trying to stay away from any other investing ideas.


Can anyone tell me what my 3 fund returns will be for the next 30 yrs?

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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Wed Jun 13, 2018 9:45 am

Larry Swedroe was generous enough to pass on the essay below he wrote about 11 years ago regarding risk based explanations for size and value premia.

Dave


Risk-Based Explanations of the Size and Value Premiums

Few objectives ever stirred explorers more than the search for the source of the Nile. In recent years there has been the financial equivalent of that hunt. While the paper, “The Cross-section of Expected Stock Returns,” has been the benchmark model for risk adjustment since its publication in the Journal of Finance in June 1992, financial economists have been trying to discover the sources of the size (the returns of small caps minus the returns of large caps) and value (the returns of value stocks minus the returns of growth stocks) premiums. While the authors, Eugene F. Fama and Kenneth R. French, argued that the size and value factors were proxies for risk, they acknowledged that they had not identified the risk factors that could explain the premiums.
The paper, “Yield Spreads as Alternative Risk Factors for Size and Book-to-Market,” sought to determine if the macroeconomic variables of default spread (the spread between the yield on seasoned Baa-rated corporate bonds and the yield on ten-year Treasury notes) and term spread (the spread between one-year and ten-year Treasuries) were alternative proxies for the size and value factors.1 The period covered by their study was July 1963 to June 2001.
The authors hypothesized that since small firms tend to have limited access to external capital markets they are more vulnerable to variations in credit market conditions over the business cycle. Thus, if credit spreads widened (narrowed) we could expect lower (higher) returns to small firms.
They also hypothesized that since high book-to-market firms were more highly leveraged, rising (declining) interest rates would have a negative (positive) effect on value stocks. And since rising (declining) interest rates correlate to a narrowing (widening) of the term spread, we should expect a narrowing (widening) of the term spread to be accompanied by lower (higher) returns to value stocks.
To summarize, small and value companies are more vulnerable to worsening credit market conditions and higher interest rates. Thus default and term spreads should be good proxies for capturing the cross-sectional pattern of returns in size and book-to-market.
Their findings can be summarizing as follows: Higher stock returns to small and value stocks are systematically related to business cycle fluctuations as indicated by the macroeconomic variables of default and term spreads. This supports the view that the higher returns to small and value stocks are compensation for risks not explained by beta (exposure to market risk).
The paper “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” came to the same conclusions.2 The author found that value (and small) companies tend to be firms under distress, with high leverage and high uncertainty of cash flow. Therefore, shocks to the default spread explains the cross-section of returns and is consistent with value being a measure of distress risk. In addition, growth stocks are high-duration assets (much of their value comes from expected future growth), making them similar to long bonds. Value stocks are low-duration assets, making them more similar to short-term bonds. Thus, shocks to the term spread (the difference between short-term bonds and long-term bonds) also explains the cross-section of returns and is also consistent with value being a measure of distress risk.
Moon K. Kim and David A Burnie also examined the relationship between firm size and performance across the economic cycle. They found that small companies grow faster than large companies in good economic times (they are less risky) but do poorly in the worst of times (their risk shows up, frequently ending in bankruptcy). Thus it is logical that the size premium should vary across economic cycles. They concluded that the size effect is really compensation for economic cycle risk.3
There are two other similar studies worth mentioning. The study “Monetary Policy and the Cross-Section of Expected Returns,” also examined the relationship between economic cycle risk and the size, as well as the value, effect. The authors used monetary policy as the variable determining economic cycle risk.4 They used three different measures of monetary policy:
• Changes in the discount rate. An increase would be viewed as a contraction of monetary policy and a decrease as an expansion.
• Changes in the Fed funds rate. An increase would be viewed as a contraction of monetary policy and a decrease as an expansion.
• Interpretation of the minutes of the Federal Reserve Board meetings.
The authors found that all three measures resulted in the same conclusions in regard to the size effect:
• When size is isolated there is a significant small firm premium only in periods of expansionary monetary policy. (Easy monetary policy is associated with falling interest rates and widening of the term spread.)
• In restrictive periods the small effect is not statistically significant.
They came to similar conclusions regarding the value effect:
• There is a significant value premium in expansionary periods.
• The premium is smaller in restrictive periods, but it still is statistically significant.
The authors concluded that monetary policy has a significant impact on the size and value effects (risk and return). Good economic times generally occur when the Fed is either expansionist in its policy or simply “leaning against the wind,” and bad times occur when the Fed is being restrictive in its policy. The authors also noted that since small and value firms are typically highly leveraged they are more negatively impacted in their ability to access capital during periods of restrictive monetary policy. Thus small and value firms are more susceptible to distress in times of restrictive monetary policy (weak economy).
Summary
As a body of work, these studies all support the hypothesis that the size and value effects are premiums related to the risk of distress. Unfortunately, there is no evidence of a persistent ability to forecast changes in either economic conditions or monetary policy in a manner that leads to abnormal trading profits. This does not mean, however, that the information has no value. Understanding the source or nature of risk premiums is of great value in helping to determine the appropriate asset allocation (amount of exposure to the value and size effects). Those investors with a high correlation of their earned income (either due to their profession or their ownership of a business) to the economic cycle should consider limiting their exposure to small and value stocks (due to the high correlation of the two risks). Those with low correlation of their earned income may be more willing to seek the greater expected returns associated with small and value companies.
1. Jaehoon Hahn and Hangyong Lee, “Yield Spreads as Alternative Risk Factors for Size and Book-to-Market,” Journal of Financial and Quantitative Analysis (June 2006).
2. Ralitsa Petkova, “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” Journal of Finance (April 2006).
3. Moon K. Kim and David A Burnie, “The Firm Size Effect and the Economic Cycle,” Journal of Financial Research, Spring 2002.
4. Gerald R. Jensen and Jeffrey M. Mercer, “Monetary Policy and the Cross-Section of Expected Returns,” Journal of Financial Research, Spring 2002.

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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Wed Jun 13, 2018 9:49 am

And here’s more references regarding the premia provided by Larry

1.Baruch Lev and Theodore Sougiannis, “Penetrating the Book-to-Market Black Box,” Journal of Business Finance and Accounting (April/May 1999).
2.Robert F. Peterkort and James F. Neilsen, “Is the Book-to-Market Ratio a Measure of Risk?” Journal of Financial Research (Winter 2005).
3.Maria Vassalou and Yuhang Xing, “Default Risk in Equity Returns,” Journal of Finance (April 2004).
4.Xinting Fan and Ming Liu, “Understanding Size and the Book-to-Market Ratio: An Empirical Exploration of Berk’s Critique,” Journal of Financial Research (Winter 2005).
5.Howard W. Chan and Robert W. Faff, “Asset Pricing and the Illiquidity Premium,” The Financial Review (November 2005).
6.Charles Lee and Bhaskaran Swaminathan, “Price Momentum and Trading Volume,” Journal of Finance (October 2000).
7.Ralitsa Petkova, “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” Journal of Finance (April 2006).
8. Aydin Akgun and Rajna Gibson, “ Recovery Risk in Stock Returns,” Journal of Portfolio Management, Winter 2001.
9. Gerald R. Jensen and Jeffrey M. Mercer, “Monetary Policy and the Cross-Section of Expected Returns,” Journal of Financial Research, Spring 2002.
10.Gabriel Perez-Quiros and Allan Timmerman, “Firm Size and Cyclical Variations in Stock Returns,” July 1999.
11.Lu Zhang, “The Value Premium.” January 2002, http://papers.ssrn.com/sol3/papers.cfm? ... _id=351060
12.Joao Gomes, Leonid Kogan, and Lu Zhang, “ Equilibrium Cross-Section of Returns, March 2001. http://assets.wharton.upenn.edu/~zhanglu/
13. Moon K. Kim and David A Burnie, “The Firm Size Effect and the Economic Cycle,” Journal of Financial Research, Spring 2002.
14.Nai-fu Chen and Feng Zhang, Journal of Business, “Risk and Return of Value Stocks,” October 1998.
15. Clifford S. Asness, Tobias J. Moskowitz, and Lasse H. Pedersen∗Value and Momentum Everywhere, February 2009.
16. Joachim Grammig, “Creative Destruction and Asset Prices,” March 2011.
17. Jia Wang, Gulser Meric, Zugang Liu, and Ilhan Meric, “The Determinants of Stock Returns in the October 9, 2007-March 9, 2009 Bear Market,” The Journal of Investing (Fall 2011).
18. Nishad Kapadia, “Tracking Down Distress Risk,” May 2010
19. Angela J. Black, Bin Mao and David G. McMillan, “The Value Premium and Economic Activity: Long-run Evidence from the United States,” December, 2009.
20. Nicolae Garleanu, Leonid Koganz, and Stavros Panageas, “Displacement Risk and Asset Returns,” July 2008.
21. Lorenzo Garlappiy and Hong Yanz, “Financial Distress and the Cross Section of Equity Returns,” September 2007

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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Wed Jun 13, 2018 9:57 am

Nedsaid,
I totally agree with your description of “price risk” for growth stocks. I’ve thought of it myself as “bubble risk” perhaps because I started my investing career in the late 1990s :-). There can be a lot of perfection built into growth stock prices, and when those expectations are not met, they can fall hard and fast.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Wed Jun 13, 2018 11:19 am

Random Walker wrote:
Wed Jun 13, 2018 9:49 am
And here’s more references regarding the premia provided by Larry
To this list I might add an article that John Cochrane wrote for Economic Perspectives, which is published by The Federal Reserve Bank of Chicago. The article is called "Portfolio advice for a multifactor world" and was published in 1999. It presents, among other things, what I think is a helpful graphical illustration of how the two-dimensional mean-variance portfolio theory can be interpreted in a world with two (or more) risk factors.

This is also relevant, I think, to a question posed earlier:
stlutz wrote:
Mon Jun 11, 2018 8:40 pm
I'm wondering whether you think that a compelling, rational reason for most investors to take the other side of the trade should be such a criteria?
Cochrane starts with a diagram of the classic mean-variance optimization (MVO) frontier.

Image

He then presents a hypothetical additional risk factor, which he calls a "recession factor" but you can imagine any factor you might like. In this world, indifference curves become indifference surfaces. Then he illustrates the choices investors have.

Image
As with figure 1, we must next think about what is available. We can now calculate a frontier of portfolios based on their mean, variance, and recession sensitivity. This frontier is the multifactor efficient frontier. A typical investor then picks a point as shown in panel A of figure 2, which gives him the best possible portfolio􏰖 – trading off mean, variance, and recession sensitivity􏰖that is available. Investors want to hold multifactor efficient, rather than mean-variance efficient, portfolios. As the mean-variance frontier of figure 1 is a hyperbola, this frontier is a revolution of a hyperbola.
Cochrane then summarizes how investors might allocate their portfolios in such a world.
As every point of the mean-variance frontier of figure 1 can be reached by some combination of two funds – 􏰖a risk-free rate and the market portfolio􏰖 – now every point on the multifactor efficient frontier can be reached by some combination of three multifactor efficient funds. . . .
Investors now may differ in their desire or ability to take on recession-related risk as well as in their tolerance for overall risk. Thus, some will want portfolios that are farther in and out, while others will want portfolios that are farther to the left and right. They can achieve these varied portfolios by different weights in the three multifactor efficient portfolios, or three funds.
Cochrane then goes on to explain the implications for mean-variance investors.
The mean-variance frontier still exists – 􏰖it is the projection of the cone shown in figure 2 on the mean- variance plane. As the figure shows, the average investor is willing to give up some mean or accept more variance in order to reduce the recession-sensitivity of his portfolio. The average investor must hold the market portfolio, so the market return is no longer on the mean-variance frontier.

Suppose, however, that you are concerned only with mean and variance􏰖 you are not exposed to the recession risk, or the risks associated with any other factor, and you only want to get the best possible mean return for given standard deviation. If so, you still want to solve the mean-variance problem of figure 1, and you still want a mean-variance efficient portfolio. The important implication of a multifactor world is that you, the mean-variance investor, should no longer hold the market portfolio.

You can still achieve a mean-variance efficient portfolio just as in figure 1 by a combination of a money market fund and a single tangency portfolio, lying on the upper portion of the curved risky-asset frontier. The tangency portfolio now takes stronger positions than the market portfolio in factors such as value or recession-sensitive stocks that the average investor fears.
The whole article is worth reading, I think, if you're interested in how the extra dimensions of risk we are talking about might impact (or not impact) your view of how a portfolio should be constructed.

There is one other bit later in the article that I think is also worth quoting when he discusses whether the effects are "real" or behavioral.
Similarly, the predictability of stock returns over time is interpreted as waves of irrational exuberance and pessimism as often as it is interpreted as time-varying, business cycle related risk or risk aversion. Those who advocate an economic interpretation point to the association with business cycles (Fama and French, 1989) and to some success for explicit models of this association (Campbell and Cochrane, 1999); those who favor the irrational investors view point out that the rational models are as yet imperfect.

While this academic debate is entertaining, how does it affect a practical investor who is making a portfolio decision? At a basic level, it does not. If you are not exposed to the risk a certain investment represents, it does not matter why other investors shy away from holding it.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: What Makes Factors Endure

Post by packer16 » Thu Jun 14, 2018 5:49 am

IMO factors have only been put to the test since the mid 2000s with real money when they were first invested in any real scale. To think that with more money invested this way that they will not go the way of active investing due to the same factors that reduced the value of active investing is naive. Active investing started in the 1960s & it took 40 years to make it on average not useful. If we use the same timeline (maybe faster given how quickly things change) then by the 2040s factor investing should be in the same boat. It is how markets work. Until then it will act more & more like active then low cost indexing under-performing over longer periods of time and on average generating lower returns.

One issue no one has been able to provide is how do you know when the any factor is not longer useful in providing expected returns in excess of the market. The only way is to experience low returns. An example others have provided is the idea of measuring the difference high & low P/BV or P/E stocks as a metric. This assumes that the companies in both sets are of equal quality over time. I have not seen data to support this & I think if the market is getting more efficient you would expect the opposite, the low P/BV and P/E stocks to be getting crappier and crappier over time. One interesting test would be to see if value returns are driven by crappy stock returns or by higher quality stock returns in the low P/BV or P/E bucket.

As to the test of persistence over time, I think the data series is too short to draw a conclusion. The aspect of the market changing as a result of factor investing is also being ignored by some. It is interesting that factor investing is showing the characteristics of active investing when in began to work less & less. Factors are not fundamental characteristics that stocks have because they can change over time. We will see.

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Thu Jun 14, 2018 9:00 am

packer16 wrote:
Thu Jun 14, 2018 5:49 am
IMO factors have only been put to the test since the mid 2000s with real money when they were first invested in any real scale. To think that with more money invested this way that they will not go the way of active investing due to the same factors that reduced the value of active investing is naive. Active investing started in the 1960s & it took 40 years to make it on average not useful.
Factor investing has definitely grown more sophisticated in the past dozen or so years, but it goes back much further than many people might imagine. Small cap and value investing both make use of factors and people have been investing serious money in both styles for many decades (Vanguard's small cap index fund was started in 1960, albeit as an active fund). Dimensional Fund Advisors, a mutual fund company dedicated almost entirely to investing using style and risk factors, was founded in 1981 - just six years after Vanguard.

As for active mutual funds, I think it'd be fair to say that while it may have taken economists a while to REALIZE that they were not delivering great returns for investors I'm not sure there is much evidence that they ever did.

William Sharpe wrote a paper in 1965 called "Mutual Fund Performance" in which he examined the returns of 34 mutual funds form 1954 to 1963. He found that most mutual funds underperfomed the index (DJIA) after expenses and that a fund's expense ratio was the best single predictor of its future performance.

If active mutual funds ever had a period of being, on average, more useful to their investors than to their managers then it must have been before 1954.

It's true that CAPM didn't come along until nearly 10 years after Sharpe's observations and Fama-French another 10 years after that, but I wouldn't characterize factor investing as some new-fangled development
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Re: Larry Swedroe: What Makes Factors Endure

Post by nedsaid » Thu Jun 14, 2018 9:26 am

Random Walker wrote:
Wed Jun 13, 2018 9:57 am
Nedsaid,
I totally agree with your description of “price risk” for growth stocks. I’ve thought of it myself as “bubble risk” perhaps because I started my investing career in the late 1990s :-). There can be a lot of perfection built into growth stock prices, and when those expectations are not met, they can fall hard and fast.

Dave
I think the best investors can do is try to use valuations to manage risk. Rebalancing your portfolio helps with this a lot as you tend to rebalance from expensive to cheap over time. One could try, as I have a couple of times, to do a bit of strategic asset allocation. My largest shift was 15% of my portfolio back in early 2000 as I shifted from stocks to cash. That certainly reduced my risk profile but hard to say if it boosted returns.

I did a similar shift from cash to bonds in 2005, pretty much taking most of the cash from 2000 and putting it to work in bonds. One reason was Bogle's comment that cash was for savers and not investors. Again, hard to say if that really increased my returns. I perceived opportunity there and it seemed to work. Maybe.

The third tweak was my program of mild rebalancing starting in July 2013 with the "taper tantrum". It seemed that both rising stock prices and falling bond prices was a good rebalancing opportunity. Have been doing mild rebalancing from stocks to bonds since then. Has this boosted returns. No. Has it helped manage risk? Maybe.

It is the old being right too early problem. Euphoria can last longer than what the experts would think. Expensive can stay expensive a long time. This is what drives market timers crazy and this is why I have market timed only in its mildest forms.

As far as the Value premium, I have been beating the drums for Large Value for probably three years, maybe longer. The market stubbornly refuses to listen. Maybe someday I will be right.
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Re: Larry Swedroe: What Makes Factors Endure

Post by nedsaid » Thu Jun 14, 2018 9:36 am

indexonlyplease wrote:
Wed Jun 13, 2018 9:27 am
Well I would say most of this is over most of our heads. Eventhough I read the books I still have a hard time understanding. So, if I own the 3 fund (which I do) I have bought into the belief that Total Market is the way to go for me. And I believe in Market Cap. Investing.


So does this just tell me I am willing to take what the market will give me?? I may get lucky by some other investing or tilting on some funds. But is my simple investing mind ok with what the market will give me??

I sure hope so because I decided 3 years ago to head this way. Trying to stay away from any other investing ideas.


Can anyone tell me what my 3 fund returns will be for the next 30 yrs?
The basic concepts behind factors are not difficult to explain. It is the mathematical and statistical detail that gets hard to process. When things get too much quantspeak, then my eyes start to glaze over. All the math and statistics are helpful in illuminating the issues but at some point I just lose interest. It seems better for me to tell a story and then provide some, but not too much, math and statistical support. When the bell shaped curves get trotted out, I just sort of start getting numb upstairs. Simpler graphs seem to help. I understand distribution of returns and the right and left tails. I had a good introduction to statistics in college but obviously I am not a Mathematician. I have a D and a C in Calculus to prove it.
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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Thu Jun 14, 2018 9:53 am

I, like Packer16, intuitively feel that markets will always be more efficient and perhaps “smarter” than we can ever imagine. This especially concerns me with regard to behavioral anomalies. Nonetheless risk stories make lots of sense and the market prices risk. There are substantial limits to arbitrage and human behavior is stubbornly consistent. Then of course, there is the data supporting the factors. Put it all together and I’ve decided to go the factor route despite the costs.
One thing that I always ponder is how market efficiency has or has not changed over time. I think we are all subject to believing that with computers, internet, artificial intelligence, etc, markets are unbelievably efficient now compared to the past. But I think markets of the 1990s, 1960s, 1860s, and 1600s were efficient too, and we can learn from them.
When looking at data, I certainly like looking at both the longest series available and recent series too because they might be more applicable to current investing circumstances.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by packer16 » Thu Jun 14, 2018 10:05 am

IMO your narrative includes a myth that factor investing is the same as the investing value investors have been following for years. This is not true. Value investing is not factor investing. Value investing is based upon having a deep understanding of businesses & valuation of those businesses. Factor investing is a form a quantitative investing that uses an empirically derived relationship between return and valuation ratios (i.e what drives stock prices not what companies are worth). In value investing an intrinsic value is developed using the appraisal method as described by Graham which includes as one method the valuation ratios used in factor investing. One of the reasons factor investing is cheaper is it uses a shortcut method to estimate the value of businesses. Once the same methods are used over & over again one only expects that returns will fall.

It is also a myth that active investing never worked. It worked for a long time. See writing by Charles Ellis on this. It worked because you had amateurs trading against professionals who had better information. Once the market became more & more professionals, this edge went away and so did the out-performance. As more & more folks use factors the same will happen. With factor investing we maybe close to this edge. I listen to a recent podcast by Jason Karp interviewed by Patrick O'shaunessey. At about 4 minutes into the podcast he said he has evidence that quant (which factors are a part of) represents about 90%+ of the trading volume today vs. fundamental investors. He has said there was a massive increase in quants in the 04 timeframe, not a coincidence that the ratio of SCV return/S&P peaked in 2006 and has wandered around that level since. Just my 2 cents.

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Thu Jun 14, 2018 12:49 pm

packer16 wrote:
Thu Jun 14, 2018 10:05 am
Value investing is based upon having a deep understanding of businesses & valuation of those businesses.
This is certainly what most active value investors believe (or, at the very least, claim) but the question is, what are active value investors ACTUALY doing?

They are combing through companies looking for common characteristics that lead to outperformance. That's factor investing.
packer16 wrote:
Thu Jun 14, 2018 10:05 am
It is also a myth that active investing never worked. It worked for a long time. See writing by Charles Ellis on this.
Do you mean the Charles Ellis who said “The investment management business (it should be a profession but is not) is built upon a simple and basic belief: Professional money managers can beat the market. That premise appears to be false.”?

In his famous article "The Loser's Game" from 1975, Ellis does indeed chalks up the inability of active managers to beat the market to unspecified "important changes in the past ten years". But he offers no evidence that active managers used to beat the market, and the Sharpe article from 1965 I quoted earlier showed that active managers didn't beat the market before that either.

In any event, we have lots of research which shows us that the average active mutual fund manager is plenty smart: they can generally pick stocks that do slightly better than average. Just not ENOUGH better to cover the expenses of the manager and, therefore, deliver outperformance to the client.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: What Makes Factors Endure

Post by packer16 » Thu Jun 14, 2018 1:12 pm

What active investors are doing is valuing companies & securities. They are understanding businesses and what drives value. I did this a business for the past 20 years primarily for private business. It much more involved that running factor screens and developing portfolios with the output of these screens, which is what factor investing is. Fundamental value investing is not factor investing. If you read Ben Graham' Security Analysis you can see the difference between fundamental security analysis and running screens & putting portfolios together.

Factor investing takes the result (good returns) and works backwards to find out what created that result over a given period in history. While this is interesting & easily automatable into an investment strategy, it is nothing more than mining data & finding out what has worked. Not that this is bad it works in many fields where the underlying variables are constant and not changing. It is backward looking & dependent upon the market being the same as history for it to work. There are some factors that carry over time but what you will find with factor investing is the results always work better in history than going forward in part because others know this and move the prices in ways that cannot be modeled.

If you read Charles Ellis' recent article in FAJ you will see his view of active management over time. In addition, he has a short video (on the CFA website) where he also expresses this view. Active management worked historically that is why folks paid for it (he specifically says this in both pieces). Now what has happened later in the 1980s & 1990s was a huge marketing effort for active management which oversold the benefits just as too many participants arbed away the returns. I think we will see deja vu with factor investing. It is how markets work & why index (not factor) investing is such a powerful idea.

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Thu Jun 14, 2018 1:46 pm

packer16 wrote:
Thu Jun 14, 2018 1:12 pm
What active investors are doing is valuing companies & securities.
I fully understand the differences between active fund management, quantitative fund management, and passive fund management. I know that fundamental fund managers don't see themselves as factor investors, but the reality is that quantitative managers and fundamental managers are building the same product. They are using different tools, it's true, but the result is directly comparable.

You can create a wedding invitation using calligraphy and hand-drawn illustration or you can create it using graphic design software and an offset printer. They are two different approaches, but in the end you have the same product: a wedding invitation.

It's the same with mutual funds, and with mutual funds we have an objective way to evaluate them. We can compare the various approaches to see which produces the best risk-adjusted returns, net of expenses.

I think a lot of investors innately understand fundamental investing a lot better than they do quantitative investing, and they fixate on the technology instead of on what is actually being accomplished. The truth is that while factor-based investing is much more data-dependent and mathematically complex, factor investing and fundamental investing are just two different ways of producing portfolios of assets which share common features.

packer16 wrote:
Thu Jun 14, 2018 1:12 pm
If you read Charles Ellis' recent article in FAJ you will see his view of active management over time.
With all due respect to Ellis, who generally strikes me as a smart man, just because he believes it doesn't mean its true. I'm pretty sure I've read just about every scholarly study of mutual fund returns published in the last forty years, and I can't recall ANY of them concluding that active managers beat the market (net of expenses) in aggregate over any time period. Gross of expenses the story isn't so dire, but evidence about the ability active managers' ability to deliver excess return to clients is pretty damning.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Thu Jun 14, 2018 2:18 pm

packer16 wrote:
Thu Jun 14, 2018 1:12 pm
What active investors are doing is valuing companies & securities. They are understanding businesses and what drives value. I did this a business for the past 20 years primarily for private business. It much more involved that running factor screens and developing portfolios with the output of these screens, which is what factor investing is. Fundamental value investing is not factor investing. If you read Ben Graham' Security Analysis you can see the difference between fundamental security analysis and running screens & putting portfolios together.
Packer
There is a difference between the underlying business and the stock we invest in. The factors explain how a portfolio of stocks perform.
I believe that if one accounts for the additional profitability factor in addition to to market, size, and value factors, there is no additional alpha in the performance of a portfolio of Graham/Buffett stocks.

Dave

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Re: Larry Swedroe: What Makes Factors Endure

Post by packer16 » Thu Jun 14, 2018 3:11 pm

What about all the things that are included in factors the influence value, like future growth, moatiness of the business, the governance of the business and the governance of the country and security specific factors, like voting/non-voting stocks, holding company discounts and the implied cost of leverage in derivatives. I agree that you can explain the past with factors, the future is a different story as others including factor investors influence the future in ways not captured in the past data & the influence is becoming larger & larger as more folks invest in factors.

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Re: Larry Swedroe: What Makes Factors Endure

Post by vineviz » Thu Jun 14, 2018 3:36 pm

packer16 wrote:
Thu Jun 14, 2018 3:11 pm
What about all the things that are included in factors the influence value, like future growth, moatiness of the business, the governance of the business and the governance of the country and security specific factors, like voting/non-voting stocks, holding company discounts and the implied cost of leverage in derivatives.
Are you talking about valuing a single company are you talking about managing a mutual fund portfolio?

There is always the possibility that some idiosyncratic feature of particular company might dominate its value. On the other hand, there is a lot of research from behavioral finance which shows that even well-trained expert, using all available data, often make worse forecasts than someone just using the probability-based (average) expected values.

While we might stipulate that my personal doctor – using every piece of data from my personal medical history - MIGHT have the best estimate about my life expectancy, you can be sure that life insurance companies and other actuaries are quite adept at computing the average life expectancy for people in my cohort with VERY few data points (do I smoke, what's my occupation, what's my BMI, etc). And if you gave my medical charts to ten highly skilled doctors, I bet the average forecast they make is less accurate than the insurance company. Of course to win the bet I'd have to die first.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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Re: Larry Swedroe: What Makes Factors Endure

Post by analogsavior » Thu Jun 14, 2018 6:57 pm

I guess I can't really buy into the risk explanations for factor investing. Human (or human programmed computer) behavior seems like a much simpler and intuitive explanation. And as AI continues to evolve and take over pricing stocks completely, I imagine these premiums will become significantly harder to capture in any appreciable way.

Just 2 cents from a non-factor investor.

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Re: Larry Swedroe: What Makes Factors Endure

Post by nedsaid » Thu Jun 14, 2018 11:07 pm

analogsavior wrote:
Thu Jun 14, 2018 6:57 pm
I guess I can't really buy into the risk explanations for factor investing. Human (or human programmed computer) behavior seems like a much simpler and intuitive explanation. And as AI continues to evolve and take over pricing stocks completely, I imagine these premiums will become significantly harder to capture in any appreciable way.

Just 2 cents from a non-factor investor.
Remember the program trading in the 1980's that was supposed to help take risk out of the market? Many people feel that this only increased the effect of the 1987 stock market crash if not helping cause it.

I don't know, computers and algorithms seem to amplify human emotion. I doubt that AI will be any different. Somehow, greed and fear are still in fashion.

I suppose someone will try baffling AI by doing seemingly really irrational trades. Do weird things in the markets to try to get AI machines to do weirder things in response. I can see someone with big shorts out there trying to freak out the machines to try to get markets to crash. Make the computers just go crazy by trying to create false signals in the markets.

Certainly AI will be a bigger factor in markets but I am skeptical that human emotion will be taken out.
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Re: Larry Swedroe: What Makes Factors Endure

Post by Random Walker » Thu Jun 14, 2018 11:37 pm

nedsaid wrote:
Thu Jun 14, 2018 11:07 pm

Certainly AI will be a bigger factor in markets but I am skeptical that human emotion will be taken out.
As much as I believe in ruthlessly efficient markets always getting more so, I tend to agree. Just think human emotion can’t get sucked out of the markets no matter how advanced the gizmology gets.

Dave

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