Factor ETFs For Diversification Or “Diworsification”

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typical.investor
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 1:21 am

fennewaldaj wrote:
Mon May 20, 2019 1:06 am
pdavi21 wrote:
Mon May 20, 2019 12:50 am


Small growth funds have had more volatlity than small value in most cases. Not sure why I keep hearing that small value is riskier.
I think the idea is that value stocks have a risk that is not reflected by volatility. Could be something like all the this time it is different narratives end up being true and most of the value companies end up going out of business. That is the narrative that is pushed everytime growth does well. It may eventually end up being true. That is a real risk you are taking on with these companies.
Yeah an another thing is that value underperforms for long periods. So if you are younger, it makes more sense to hold more growth. Then if you have a job loss, you are more likely to be better off.

As investors get more wealthy they tend to shift assets to value. It's like earning an insurance premium for holding the stocks that only do well less periodically.

In any case, if size and value explain 90% of returns for diversified portfolios, then why is a portfolio (as suggested in this thread) of 25% size/value, 25% momentum, 25% low volatility and 25% quality called "diversification"?

Why have 75% of your portfolio in the factors that explain 10% of returns. I understand at times that the correlation is low, but there is nothing to say these factors aren't derived from common elements such as growth and inflation.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 1:39 am

pdavi21 wrote:
Mon May 20, 2019 1:16 am
Which definition of risk supports the assertion that value funds are riskier? Losing?
Well aren't companies with a higher book much more difficult to evaluate should the need to liquidate arise. You have to sell equipment that was obtained for a particular purpose into perhaps a depressed market. Who knows what you could get.

Growth companies don't have that problem as much, and also offer a higher upside should things go well.

If you've been a value investor this last decade, you maybe wish you hadn't. Its prospects certainly seem less certain unless something changes and who knows when that will be.

Volatility over 5 years seems easier to take than potentially decades of underperformance.

And as Taylor mentioned, what if that bad period drags into your retirement. Hopefully you have enough that it doesn't matter as value won't underperform that badly and in enough time even offer a premium. Surely it's a risk though.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 3:09 am

pdavi21 wrote:
Mon May 20, 2019 1:16 am
Growth isn't a factor, but neither is value in my context.
Reality is the only "context" I'm interested in, and in reality you're half right: growth isn't a factor, but value most certainly is.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 3:46 am

vineviz wrote:
Mon May 20, 2019 3:09 am
pdavi21 wrote:
Mon May 20, 2019 1:16 am
Growth isn't a factor, but neither is value in my context.
Reality is the only "context" I'm interested in, and in reality you're half right: growth isn't a factor, but value most certainly is.
Silly.

Are we intentionally ignoring how factors are constructed now?

If the value premium is negative, it means growth has outperformed. It's cutesy cutesy to claim growth isn't a factor but in actual reality it's an arbitrary naming convention to call it the "value factor" which I ignores that it's actually measuring the relative performance of the two.

Just read the math. It's not complicated.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 4:06 am

typical.investor wrote:
Mon May 20, 2019 3:46 am
Are we intentionally ignoring how factors are constructed now?
On the contrary, I'm paying very close attention to the way that factors are constructed.

Take a look at the datasets provided by Ken French, AQR, MSCI, or Alpha Architects and find the returns for a "growth factor".

Or read Fama & French's article "A five-factor asset pricing model" and tell me which one of the five is "growth".
typical.investor wrote:
Mon May 20, 2019 3:46 am
If the value premium is negative, it means growth has outperformed.
No, it doesn't. Growth isn't a factor, and it's not the opposite of "value". The opposite of "value" is "expensive".

If the value premium is negative, it means that cheap stocks have underperformed expensive stocks.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 4:13 am

vineviz wrote:
Mon May 20, 2019 4:06 am
typical.investor wrote:
Mon May 20, 2019 3:46 am
Are we intentionally ignoring how factors are constructed now?
On the contrary, I'm paying very close attention to the way that factors are constructed.

Take a look at the datasets provided by Ken French, AQR, MSCI, or Alpha Architects and find the returns for a "growth factor".

Or read Fama & French's article "A five-factor asset pricing model" and tell me which one of the five is "growth".
The value factor is HML.

HML (High Minus Low) is the average return on the two value portfolios minus the average return on the two growth portfolios,

HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth).

If HML is negative, it means that Growth has outperformed.
vineviz wrote:
Mon May 20, 2019 4:06 am
typical.investor wrote:
Mon May 20, 2019 3:46 am
If the value premium is negative, it means growth has outperformed.
No, it doesn't. Growth isn't a factor, and it's not the opposite of "value". The opposite of "value" is "expensive".

If the value premium is negative, it means that cheap stocks have underperformed expensive stocks.
HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth).

If HML is negative, it does indeed mean that Growth has outperformed. It's not complicated math and is true by definition.

That definition is given by Kenneth R. French by the way at https://mba.tuck.dartmouth.edu/pages/fa ... ctors.html
Last edited by typical.investor on Mon May 20, 2019 4:23 am, edited 1 time in total.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 4:23 am

typical.investor wrote:
Mon May 20, 2019 4:13 am
The value factor is HML.

HML (High Minus Low) is the average return on the two value portfolios minus the average return on the two growth portfolios,

HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth).
Sorry, that's simply incorrect. Whatever source you're referring to has got it wrong.

It's true the value factor is referred to as HML (high minus low), but the "high" refers to "high book-to-market ratio" and the "low" refers to "low book-to-market ratio" at least in the Fama-French model.

The methodology is in the published papers. If you're genuinely interested, I suggest you consult them instead of relying on whatever summary you've found on the internet.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 4:28 am

vineviz wrote:
Mon May 20, 2019 4:23 am
typical.investor wrote:
Mon May 20, 2019 4:13 am
The value factor is HML.

HML (High Minus Low) is the average return on the two value portfolios minus the average return on the two growth portfolios,

HML = 1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth).
Sorry, that's simply incorrect. Whatever source you're referring to has got it wrong.
You bring it up with Kenneth R. French and tell him he's got it wrong then. When he changes his page at Dartmouth, I will adopt your view. Until that time, I will go by what French has publicly stated as he should know. Fama & French - get it? And notice the page is conveniently titled "Description of Fama/French Factors".

I see no point in discussing this further. I mean if we aren't going to believe French, then this whole conversation is really entirely meaningless.

Again, it's here. https://mba.tuck.dartmouth.edu/pages/fa ... ctors.html

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 4:49 am

typical.investor wrote:
Mon May 20, 2019 4:28 am
You bring it up with Kenneth R. French and when he changes his page at Dartmouth, then I will adopt your view. Until then, I will go by what French has publicly stated as he should know. Fama & French - get it?
I see now that French is referring to the low market-to-book portfolios as "growth", so your confusion is understandable. When I studied finance with Fama, he never let us call those portfolios "growth" portfolios, because nothing in their construction was actually measuring growth. Maybe they've adopted the colloquial usage now, which is unfortunate.

Either way, I think it's important that you read the papers to see what it is being done so that you can understand this stuff for yourself. You'll see that HML is the factor, and it's a long-short portfolio that is long cheap stocks and short expensive stocks.

Using "growth" as a synonym for "expensive" is not only confusing and inconsistent with the way the factor portfolios are constructed, it's also not consistent with the way that major indexes or benchmarks are constructed. Unlike Fama-French, S&P and Russell ARE explicitly measuring growth (along with momentum in the S&P indices) in composing their style indices. This is one reason that comparing "value" funds with "growth" funds doesn't actually shed a whole lot of light on the value factor itself.
"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: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 5:39 am

vineviz wrote:
Mon May 20, 2019 4:49 am
I see now that French is referring to the low market-to-book portfolios as "growth", so your confusion is understandable.
My confusion? Pardon me.
vineviz wrote:
Mon May 20, 2019 4:49 am
Either way, I think it's important that you read the papers to see what it is being done so that you can understand this stuff for yourself. You'll see that HML is the factor, and it's a long-short portfolio that is long cheap stocks and short expensive stocks.
I think it's important for you to understand what you are saying. It doesn't seem like you really do. Maybe if you took some more time to consider it a little more carefully.

If you, yourself, do read Fama French carefully enough to understand it, you will see they sometimes also "use earnings-price ratios (E/P) rather than book-to-market ratios (B/M) to separate value and growth stocks" (1).

Yes, earnings-price ratios is very much a valuation measure. But that's not what they typically sort on. It's B/M.

I am pretty sure the phrase "book-to-market value-growth indicator" will cause you all sorts of problems to understand, but there it is in the literature.

Despite your claims to have studied with Fama, I don't see your interpretation as consistent with their writings ... even the ones you quote. The consistently use the terms "High B/M value stocks" and "low B/M growth stocks" (2). This, again, is as B/M is their definition of value/growth and not earnings-price ratios (E/P) which obviously is a truer measure of expense.

I think you very much want to promote factor investing by painting the story that Total Market lacks exposure to particular factors when, in fact, it contains all elements that the factors are derived from. Thus you claim there is such a thing as "Value" but not "Growth".

If HML represents the "Value Factor" and is
1/2 (Small Value + Big Value) - 1/2 (Small Growth + Big Growth)
, then it obviously follows we could define a "Growth Factor" as
1/2 (Small Growth + Big Growth) -1/2 (Small Value + Big Value)
It's merely convention that we call this relationship the "Value Factor". By definition though, it is the relationship between Value and Growth.


(1) The Value Premium and the CAPM
Eugene F. Fama and Kenneth R. French

(2)A Five-Factor Asset Pricing Model
Eugene F. Fama and Kenneth R. French

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 6:54 am

typical.investor wrote:
Mon May 20, 2019 5:39 am
It's merely convention that we call this relationship the "Value Factor". By definition though, it is the relationship between Value and Growth.
I'm not sure what about this is so confusing.

It's specious to say it is "merely convention" that HML is referred to as the value factor: we call it that because the measure being used to construct it, market-to-book ratio, is and always has been considered a valuation metric going back at least to Graham and Dodd in the 1930s.

No rational investor, before or after Fama-French, would use market-to-book ratio as a measure of growth.

Interesting but irrlevenat footnote: Rex Sinquefield, who co-founded DFA, was the first (AFAIK) to label the HML factor as the "value factor". No one, to my knowledge, calls it a "growth factor".
"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: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 6:58 am

typical.investor wrote:
Mon May 20, 2019 5:39 am
I think you very much want to promote factor investing by painting the story that Total Market lacks exposure to particular factors when, in fact, it contains all elements that the factors are derived from.
I'm much less interested in promoting factor investing than in promoting a better understanding of factor investing.


To say that the total stock market "contains all elements that the factors are derived from" is obfuscatory, since a portfolio's factor loading is defined as its net exposure to that factor. If your net exposure to a factor is zero (as it is in the total stock market fund for all factors except market beta), you're not exposed to that factor.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Lastrun » Mon May 20, 2019 7:39 am

typical.investor wrote:
Mon May 20, 2019 1:21 am


In any case, if size and value explain 90% of returns for diversified portfolios, then why is a portfolio (as suggested in this thread) of 25% size/value, 25% momentum, 25% low volatility and 25% quality called "diversification"?

Why have 75% of your portfolio in the factors that explain 10% of returns. I understand at times that the correlation is low, but there is nothing to say these factors aren't derived from common elements such as growth and inflation.
I think it may even be stronger than 90%--the wiki claims market, size and value "explain" 95% citing this Dimensional white paper by Fama https://www.ifa.com/academic-papers/mul ... a_2006.pdf

But I struggle with the question. No so much of a "how much to tilt" question, but how to achieve a sufficient diversification benefit with the least amount of tilt.

I also realize that the research is moving forward--heard Fama say once or twice that you could throw value out of their five-factor model and make it a four-factor model

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Random Walker » Mon May 20, 2019 7:59 am

pdavi21 wrote:
Mon May 20, 2019 1:16 am
Which definition of risk supports the assertion that value funds are riskier?
A common phrase is “doing badly in bad times”. A stock that does poorly at the same time the investor is losing his job carries an additional dimension of risk.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nedsaid » Mon May 20, 2019 8:26 am

vineviz wrote:
Mon May 20, 2019 1:03 am
pdavi21 wrote:
Mon May 20, 2019 12:50 am
Small growth funds have had more volatlity than small value in most cases. Not sure why I keep hearing that small value is riskier.
It could be in part that small growth funds haven’t actually exhibited more volatility than value funds.

It could be that “growth” isn’t a factor, and definitely isn’t the opposite of “value.

It could be that volatility isn’t the only way to measure risk.

Or maybe it’s all three.


It could be that
Well, Growth isn't considered a factor but a couple things associated with Growth are, Profitability/Quality and Momentum. That is part of the paradox with factors.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by typical.investor » Mon May 20, 2019 8:46 am

Lastrun wrote:
Mon May 20, 2019 7:39 am
typical.investor wrote:
Mon May 20, 2019 1:21 am


In any case, if size and value explain 90% of returns for diversified portfolios, then why is a portfolio (as suggested in this thread) of 25% size/value, 25% momentum, 25% low volatility and 25% quality called "diversification"?

Why have 75% of your portfolio in the factors that explain 10% of returns. I understand at times that the correlation is low, but there is nothing to say these factors aren't derived from common elements such as growth and inflation.
I think it may even be stronger than 90%--the wiki claims market, size and value "explain" 95% citing this Dimensional white paper by Fama https://www.ifa.com/academic-papers/mul ... a_2006.pdf
That's a good read. I like the explanation for why the market likely places a lower value on high book-to-market companies - uncertainty of earnings. Less certainty equates more risk. That is surely true of value which is prone to droughts.
Lastrun wrote:
Mon May 20, 2019 7:39 am
But I struggle with the question. No so much of a "how much to tilt" question, but how to achieve a sufficient diversification benefit with the least amount of tilt.
Well if it's a large enough amount to make a difference when it does well, it's a sufficient amount to hurt when it does poorly.

I think you might get a premium from factor diversification, but I don't expect diversification to reduce drawdowns - do you? That's why I take such exception with how factors get presented here.
Excess kurtosis measures the extent to which we observe extreme realizations in both directions.
excess kurtosis for all factors is positive, and for some factors is considerably positive, suggesting that
extreme realizations are not infrequent
we show that the excess kurtosis for the portfolios of factors is similar to the excess kurtosis of the individual factors. Therefore, the worst
monthly drawdowns for the portfolios of factors were not much better than the average of the worst single-factor drawdowns
Forming portfolios of factors does not mitigate the risk of large drawdowns to the extent we might expect, because the large drawdowns of individual factors often happen at the same time
Alice’s Adventures in Factorland:
Three Blunders That Plague Factor Investing
https://www.researchaffiliates.com/en_u ... sting.html

I do use factor funds (mostly RAFI), but I don't think any factor funds will necessarily diversify my portfolio when the portfolio needs it the most. “Diworsification” is pejorative though so I don't call it that either.
Lastrun wrote:
Mon May 20, 2019 7:39 am
I also realize that the research is moving forward--heard Fama say once or twice that you could throw value out of their five-factor model and make it a four-factor model
Yeah, I believe DFA value funds now do a screen on profitability in addition to HML. Helps eliminate the cheap for a very good reason stocks.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 9:07 am

Lastrun wrote:
Mon May 20, 2019 7:39 am
But I struggle with the question. No so much of a "how much to tilt" question, but how to achieve a sufficient diversification benefit with the least amount of tilt.
Considering - by way of example - a 2-fund portfolio of Vanguard Total Stock Market ETF (VTI) and Vanguard S&P Small-Cap 600 Value ETF (VIOV), the maximum diversification comes at roughly 57% VTI and 43% VIOV.

At 70% VTI and 30% VIOV you are getting over 90% of the diversification benefit, and at 80% VTI and 20% VIOV you are getting nearly 75% of the benefit.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 9:30 am

typical.investor wrote:
Mon May 20, 2019 1:39 am
pdavi21 wrote:
Mon May 20, 2019 1:16 am
Which definition of risk supports the assertion that value funds are riskier? Losing?
Well aren't companies with a higher book much more difficult to evaluate should the need to liquidate arise. You have to sell equipment that was obtained for a particular purpose into perhaps a depressed market. Who knows what you could get.

Growth companies don't have that problem as much, and also offer a higher upside should things go well.

If you've been a value investor this last decade, you maybe wish you hadn't. Its prospects certainly seem less certain unless something changes and who knows when that will be.

Volatility over 5 years seems easier to take than potentially decades of underperformance.

And as Taylor mentioned, what if that bad period drags into your retirement. Hopefully you have enough that it doesn't matter as value won't underperform that badly and in enough time even offer a premium. Surely it's a risk though.
Growth companies are actually riskier because they need sometimes 20-50+% profit growth annually to justify their valuations. Tesla less risky than Ford? AMD less risky than Intel?

And it was over twenty years of higher volatility for the majority of Vanguard's Growth Funds (vs value counterpart).
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 9:32 am

vineviz wrote:
Mon May 20, 2019 3:09 am
pdavi21 wrote:
Mon May 20, 2019 1:16 am
Growth isn't a factor, but neither is value in my context.
Reality is the only "context" I'm interested in, and in reality you're half right: growth isn't a factor, but value most certainly is.
Reality is that you have to pick a FUND. Not a factor. Can we call growth an anti-factor then?

EDIT: Semantics aside, I don't think the argument that value funds are riskier is solid. If you pick all the value stocks out, it may be riskier then total market, but the stocks you have left (with high valuations), in my opinion, are riskier because they rely on something they don't have yet to justify valuations. Also, I believe they are at higher risk of insolvency during tightening market conditions due to the generally lower (even negative) profit margins.
Last edited by pdavi21 on Mon May 20, 2019 9:41 am, edited 1 time in total.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 9:36 am

Random Walker wrote:
Mon May 20, 2019 7:59 am
pdavi21 wrote:
Mon May 20, 2019 1:16 am
Which definition of risk supports the assertion that value funds are riskier?
A common phrase is “doing badly in bad times”. A stock that does poorly at the same time the investor is losing his job carries an additional dimension of risk.

Dave
Growth, on average did worse in bad times than Value over the last twenty years. 2000-2003 was a good example of that.

Perhaps, if you are talking about the value factor itself, it may be riskier over the last 100 years, but growth FUNDs (which can be invested in) have generally had higher volatility and performed worse in pullbacks than their value counterparts.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nisiprius » Mon May 20, 2019 9:37 am

Fama, in an interview no longer available on Dimensional's website, said:
Interviewer: Some people... assume that you would recommend most investors have a big helping of small and value stocks in their portfolios. Is that a fair representation of your views?

Fama: Um, no. (Laughs) Basically this a risk story the way we tell it, so there is no optimal portfolio. The way I like to talk about it when I give presentations for DFA or other people is, in every asset pricing model, the market portfolio is always an efficient portfolio. It's always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes. But that's what it amounts to. You can decide to tilt toward more value or smaller size based on your tastes for these dimensions of risk. But you needn't do it. You could also decide to go the other way. You could look at the premiums and say, no, I think I like the growth stocks better. Then, as long as you get a diversified portfolio of them, I can't argue with that either. So there's a whole multi-dimensional continuum here of efficient portfolios that anybody can decide to buy that I can't quarrel with. And I have no recommendations about because I think it's totally a matter of taste. If you eat oranges and I eat apples I can't really quarrel very much with that.
My interpretation of Fama, with several jumps and "read somewheres" added, is that Fama believes that, yes, there is a value premium but that it is explained entirely by higher risk.

By "dimensions of risk" I assume that he means things like skew or kurtosis or something. For example, I've "read somewhere" that value stocks have negative skew--they have small but consistent outperformance most of the time, but when they crash they crash badly. And that growth stocks have positive skew--they have small but consistent underperformance most of the time, but once in a while they hit the jackpot.

I've also "read somewhere," probably one of Larry Swedroe's columns, that many investors prefer positive skew.

The traditional factor maven point of view is that this is irrational, that they are overpaying, and that the rational investor exploits this by investing in value. But this is only true if you assume that there's something objectively wrong with preferring positive skew.

And Fama says "You can decide to tilt toward more value or smaller size based on your tastes... You could also... say, no, I think I like the growth stocks better... I think it's totally a matter of taste. If you eat oranges and I eat apples I can't really quarrel very much with that."

So the rational approach would seem to be to devise some kind of second-order risk tolerance measurement instrument, a risk tolerance questionnaire that assesses, not your tolerance for risk, but your preference for positive or negative skew. Or for whatever Fama means by "dimensions of risk." Let's say, a questionnaire that assesses your preference for growth or for value. OK, I don't think it's possible, but that would be the rational approach.

And the conclusion is that you should figure out what you prefer, and only tilt toward value, not because of anything you believe about risk or return, but because you prefer the "dimensions of risk" that value has.

As nearly as I can judge my personal preferences, I don't want to touch negative skew with a ten-foot pole, and if that's what value is, it's not for me.

Throw into this a bias problem. We are too apt to use what I call the "athletic model of performance assessment," that is to say counts or percentages of wins and losses. An athlete gets the same gold medal whether she wins by a minute or a millisecond. This gives a competitive advantage to managers who can create negative skew by their strategy. If, like Bill Miller, you can beat the S&P 500 fifteen years in a row, you will become personally rich, even if negative skew results in losing all of the outperformance back again in just three years.

It should be noted, by the way, that the opposite of "lottery tickets" (positive skew) is "gambling systems." These are all forms of the martingale, usually obfuscated, which in essence consists of doubling your bet every time you lose until you eventually win. Such a strategy produces a steady, regular stream of small wins that make it appear that the system is working. It produces rare catastrophic losses (you go bankrupt before you can double the bet again), but because they are rare you can brush them off as "nobody could possibly have foreseen." In gambling, of course, the long-term expected return is negative. In investing, it is (hopefully) positive. But you can still a pattern of "high chance of small outperformance, misjudged as consistent outperformance, interrupted by small catastrophic losses, that can be explained away as rare anomalies that shouldn't count."

Negative skew. Ugh. I hatesssss it, I hatesssss it I doessss. If you like it, you are welcome to your risk premium for taking it.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 10:37 am

nisiprius wrote:
Mon May 20, 2019 9:37 am
By "dimensions of risk" I assume that he means things like skew or kurtosis or something.
It's likely that he meant something else, though it can sometimes be tough to pin him down on things like this because he doesn't like to reach beyond what he thinks the data shows.

I'm quite sure he was referring to the concept illustrated by John Cochrane in an article called "Portfolio advice for a multifactor world" which I previously discussed in this post.

I won't repeat the entirety of what I wrote earlier, but the idea is that in the traditional mean-variance framework the efficient frontier is drawn in just two dimensions. If there are two sources of risk, the frontier exists in three dimensions and for n sources of risk there are n+1 dimensions.

Image

The sources of risk can represent anything investor demands compensation to bear: that could be negative skew or positive excess kurtosis, but it could also be something more economically fundamental (Cochrane uses "recession risk" as an example, but it could be "inflation risk" or even the "social risk" of not holding the current hot/popular stocks).
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by caklim00 » Mon May 20, 2019 10:46 am

typical.investor wrote:
Mon May 20, 2019 8:46 am

Alice’s Adventures in Factorland:
Three Blunders That Plague Factor Investing
https://www.researchaffiliates.com/en_u ... sting.html

I do use factor funds (mostly RAFI), but I don't think any factor funds will necessarily diversify my portfolio when the portfolio needs it the most. “Diworsification” is pejorative though so I don't call it that either.
Lastrun wrote:
Mon May 20, 2019 7:39 am
I also realize that the research is moving forward--heard Fama say once or twice that you could throw value out of their five-factor model and make it a four-factor model
Yeah, I believe DFA value funds now do a screen on profitability in addition to HML. Helps eliminate the cheap for a very good reason stocks.
I read through most of the pdf. I must be missing something though as I don't see the super significant drawdowns on MSCI Multifactor indices. Yes, 2009 is a lagging year for US Small: https://www.msci.com/documents/10199/2a ... 66e710b17c and 2008 is lagging for ExUS Small: https://www.msci.com/documents/10199/8f ... 798db32f38

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nedsaid » Mon May 20, 2019 10:49 am

pdavi21 wrote:
Mon May 20, 2019 9:30 am

Growth companies are actually riskier because they need sometimes 20-50+% profit growth annually to justify their valuations. Tesla less risky than Ford? AMD less risky than Intel?

And it was over twenty years of higher volatility for the majority of Vanguard's Growth Funds (vs value counterpart).
What you are talking about here is what I would call pricing risk. At some point, when the price gets too high, even great companies will be poor investments. Pretty much, at some point expectations get too high compared to actual earnings growth.

The risk that Value companies have is fundamental risk. More leverage on the balance sheet and volatile earnings.

Supposedly, Value stocks have a greater volatility risk but I think that is only true when the economy goes bad. That is when the risks of higher leverage show up. In other words, there is a risk that the company could go out of business.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nedsaid » Mon May 20, 2019 11:01 am

pdavi21 wrote:
Mon May 20, 2019 9:32 am
vineviz wrote:
Mon May 20, 2019 3:09 am
pdavi21 wrote:
Mon May 20, 2019 1:16 am
Growth isn't a factor, but neither is value in my context.
Reality is the only "context" I'm interested in, and in reality you're half right: growth isn't a factor, but value most certainly is.
Reality is that you have to pick a FUND. Not a factor. Can we call growth an anti-factor then?

EDIT: Semantics aside, I don't think the argument that value funds are riskier is solid. If you pick all the value stocks out, it may be riskier then total market, but the stocks you have left (with high valuations), in my opinion, are riskier because they rely on something they don't have yet to justify valuations. Also, I believe they are at higher risk of insolvency during tightening market conditions due to the generally lower (even negative) profit margins.
The "anti-factors" I have defined as the Value Traps and the Lottery stocks. Value Traps are stocks that are cheap for good reasons such as a dying industry or the company itself is dying. Pretty much companies with big problems that aren't fixed and in many cases can't be fixed. Lottery stocks are junky companies with an outside chance of hitting it big, maybe some exciting product or technology. Too often with these companies, they are all sizzle and no steak.

Growth really isn't an anti-factor, indeed two things often associated with Growth are Profitability/Quality and Momentum. So it isn't that Growth stocks are bad, you want the best of Growth companies which had rock solid balance sheets and very consistent earnings growth. You want the solid financials/earnings consistency and hopefully the bandwagon effect as more and more investors get excited. But a bandwagon effect by itself will work too.

Wall Street values consistency in earnings growth so much that it almost doesn't seem to matter whether it is fast or slow. Thus the slow growth companies with higher dividends and solid balance sheets tend to show up as Low Volatility stocks, which often have a market premium. When these type of companies are in the Value sector, they tend to have a premium. When they get bid up and show up in the Growth sector, that premium goes away. I think Larry Swedroe said that Low Volatility stocks are in the Value area of the market about 60% of the time.

I believe the factors are partly explained by risk but I can't get over the observation that there are good behavioral explanations too. Pretty much explained by good old greed and fear. Factors persist because human nature and human behavior persist.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by acegolfer » Mon May 20, 2019 11:35 am

vineviz wrote:
Mon May 20, 2019 10:37 am
Image

The sources of risk can represent anything investor demands compensation to bear: that could be negative skew or positive excess kurtosis, but it could also be something more economically fundamental (Cochrane uses "recession risk" as an example, but it could be "inflation risk" or even the "social risk" of not holding the current hot/popular stocks).
ITT, many consider volatility as the only risk investors care about. Glad to see another BHer who understand the multi-dimension efficient frontier.

Diversification lowers volatility risk. True
Diversification lowers all kinds or risk. False.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by acegolfer » Mon May 20, 2019 11:38 am

nedsaid wrote:
Sun May 19, 2019 11:09 am
I have advocated for Small/Value tilted portfolios for those who believe in Academic Research and the simple 3 fund portfolio for those that don't.
I bet Fama would disagree with this.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nisiprius » Mon May 20, 2019 11:46 am

acegolfer wrote:
Mon May 20, 2019 11:38 am
nedsaid wrote:
Sun May 19, 2019 11:09 am
I have advocated for Small/Value tilted portfolios for those who believe in Academic Research and the simple 3 fund portfolio for those that don't.
I bet Fama would disagree with this.
Fama did say:
The market portfolio is always an efficient portfolio. It's always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes. But that's what it amounts to.
It's always risky to go beyond someone's actual words, but I infer that he would say "value tilted portfolios for those who have a personal taste for value, total market portfolios for those who don't."
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by acegolfer » Mon May 20, 2019 11:51 am

nisiprius wrote:
Mon May 20, 2019 11:46 am
acegolfer wrote:
Mon May 20, 2019 11:38 am
nedsaid wrote:
Sun May 19, 2019 11:09 am
I have advocated for Small/Value tilted portfolios for those who believe in Academic Research and the simple 3 fund portfolio for those that don't.
I bet Fama would disagree with this.
Fama did say:
The market portfolio is always an efficient portfolio. It's always a relevant portfolio for an investor to hold. And investors can decide to tilt away from that based on their personal tastes. But that's what it amounts to.
It's always risky to go beyond someone's actual words, but I infer that he would say "value tilted portfolios for those who have a personal taste for value, total market portfolios for those who don't."
Correct. Whether to tilt or not has nothing to do with whether one believes in the academic research. It depends on what (specifically which risks) matters to him.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nedsaid » Mon May 20, 2019 12:02 pm

acegolfer wrote:
Mon May 20, 2019 11:38 am
nedsaid wrote:
Sun May 19, 2019 11:09 am
I have advocated for Small/Value tilted portfolios for those who believe in Academic Research and the simple 3 fund portfolio for those that don't.
I bet Fama would disagree with this.
It is a way of making peace on the forum. I believe in the Academic Research and have a mild Small/Value tilt with aggressive growth earnings and price momentum funds mixed in my portfolio. But factor tilting hasn't worked because the tech sector and in particular the FAANG stocks have done so well over the last decade. It isn't that Value has done badly, it is just that Large Growth has done better, 2% a year better. So actually, the 3 fund portfolio has beaten most Small/Value tilted portfolios over the last decade.

I keep trying to tell people that the US Total Stock Market Index and the S&P 500 are top heavy with the big tech stocks, particularly the FAANG stocks. It has also been noted that the Vanguard Growth Index now is in non-diversified status because it is even more top heavy with a few tech names. This also happened in the late 1990's as well.

I have noticed that certain 3 fund advocates have gotten more aggressive with their comments, to the point of perhaps chasing Larry Swedroe off of the forum. I have tried to gently tell people this but I doubt Larry will ever be back again, folks who should know better keep questioning his motives for his advice. I think he finally had it.

3 fund looks really good compared to tilted portfolios but the outperformance compared to Small/Value tilts is due to big Tech and in particular the FAANG (Facebook, Apple, Amazon, Netflix, and Google) stocks. It is the irony of ironies that holding the S&P 500 and the Total Market Indexes is a form of performance chasing the High Tech area of the market. Both indexes were essentially flat from 2000-2012 because of this. And it is happening again though I don't think the market is in bubble status as it was in 1999 and early 2000.

Not telling anyone to sell their US Total Stock Market Index or S&P 500 funds but just warning people that we are seeing similarities to the late 1990's. Not predicting a crash or anything like that, just saying that the Small/Value tilted portfolios will have their day again. What might be in order is a version of the "Swedroe shuffle", that is maybe exchanging a portion of Total US Market Index/S&P 500 for Large Value Index and Small Value Index. I am not there yet, but I am thinking about it. Also weird that I am reading that Warren Buffett has lost his touch, reminds me of similar articles back in the late 1990's. What is old is new again.

Again, not predicting disaster. I believe that at some point the Small/Value tilted portfolios will start outperforming the 3 fund portfolio again. Doesn't mean that I think the 3 fund approach isn't solid, even if it underperforms for a while again in the future, it is still a very good long term approach. Hard to beat those market averages.
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Post by hdas » Mon May 20, 2019 12:06 pm

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Last edited by hdas on Wed Jan 29, 2020 7:54 pm, edited 1 time in total.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Random Walker » Mon May 20, 2019 12:14 pm

If correlations between market and size, market and value, and size and value are all low, I don’t understand why Fama wouldn’t agree that diversifying a TSM portfolio into these factors should create a more efficient portfolio. By doing that one is further diversifying the portfolio into unique and independent sources of risk and return.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by acegolfer » Mon May 20, 2019 12:27 pm

nedsaid wrote:
Mon May 20, 2019 12:02 pm
acegolfer wrote:
Mon May 20, 2019 11:38 am
nedsaid wrote:
Sun May 19, 2019 11:09 am
I have advocated for Small/Value tilted portfolios for those who believe in Academic Research and the simple 3 fund portfolio for those that don't.
I bet Fama would disagree with this.
It is a way of making peace on the forum. I believe in the Academic Research and have a mild Small/Value tilt with aggressive growth earnings and price momentum funds mixed in my portfolio.
I also believe in the academic research (my profession) and understand your investment decision. But I was debating the logic behind the advice you gave to others. Whether to tilt or not should not be based solely on volatility risk. The fact that CAPM failed means there are non-volatility risks that matter to the investors.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Park » Mon May 20, 2019 12:29 pm

My greatest fear as an investor is a secular bear market. How can one mitigate the risk of a secular bear market?

Periodic investing helps.

I've seen data that in the secular bear markets that started in 1966 and 2000, tilting to value helped. And I've seen data from overseas markets ( Japanese secular bear starting in 1990 and European one starting in 2000) that tilting to value helped.

It didn't help in 1929. But there was deflation in that time, and the greater leverage of value stocks was an issue. With fiat currencies, deflation is less of a risk.

Value stocks can underperform, and for extended periods of time. But when value stock underperform, they still do reasonably well. And reasonably well is good enough for me.

I'm not convinced of the need for multifactor funds. I haven't seen data that these funds can mitigate the risk of a secular bear market. However, such funds will dilute out the value factor. The one exception to this dilution is the small factor, where the data supporting a small value premium is stronger than that for the large value premium.

OTOH, how much does one want to invest in 3% of the total stock market? Although you're diversifying among factors in that 3%, there is a loss of diversification, when you ignore the other 97%.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by acegolfer » Mon May 20, 2019 12:45 pm

Random Walker wrote:
Mon May 20, 2019 12:14 pm
If correlations between market and size, market and value, and size and value are all low, I don’t understand why Fama wouldn’t agree that diversifying a TSM portfolio into these factors should create a more efficient portfolio. By doing that one is further diversifying the portfolio into unique and independent sources of risk and return.

Dave
Seems your "more efficient portfolio" only considers volatility and ignores all other risks. In Fama world, there are other risks. See Cochrane's paper above to see what the efficient frontier looks like in a multi-factor model.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 12:45 pm

hdas wrote:
Mon May 20, 2019 12:06 pm
To bring the thread to the practical side, here's a portfolio very similar to my "Beta" retirement portfolio, it has performed a bit better than to just holding VTI, but according to the factor investing theory is better diversified across all the standard risk factors (albeit negative alpha). 0.15% ER.
That's a great illustration of a well-diversified US stock portfolio. In fact, I doubt you could get much more diversification without adding bonds and/or some ex-US holdings.

Nicely done.
hdas wrote:
Mon May 20, 2019 12:06 pm
vineviz wrote:
Mon May 20, 2019 1:03 am

It could be that “growth” isn’t a factor, and definitely isn’t the opposite of “value.
Totally agree with you that growth isn't the opposite of value. But isn't earnings growth a factor in the sense that is a independent variable that partially explains stock performance?
When Morningstar developed the equity style box (which weren't based on factors as much as they were on classic ad hoc fund categories), it became a powerfully simple way to explain mutual fund performance. I suppose it was not completely an accident that the style box captures the first two factors that Fama-French added to the CAPM, but it definitely built an implicit expectation among investors that value and growth were two ends of the same dimension.

Anyway, when I say that growth isn't a factor I really mean that it's not a statistically valid factor. You could, of course, sort the universe of stocks by some growth metric (EPS growth rate or whatever) and construct long-short portfolios in the same manner that the HML and SMB portfolios were constructed. Billions of CPU cycles have been wasted by researchers doing just that.

When you do it, though, what you find is that the growth metrics don't improve the pricing model. In other words, they don't add enough explanatory power to justify their inclusion. That's the reason that none of the factor researches (Fama-French, Carhart, Asness, MSCI, etc.) include it in their models or smart beta products..

Whatever performance typical growth funds exhibit is generally explainable by accepted factors (beta, size, value, momentum, and quality): adding explicit growth terms to the regression doesn't help explain the cross-section of returns.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 12:49 pm

Park wrote:
Mon May 20, 2019 12:29 pm
My greatest fear as an investor is a secular bear market. How can one mitigate the risk of a secular bear market?
During portfolio accumulation, periodic investment (and you observe) is the most powerful tool you have.

During portfolio decumulation (i.e. retirement withdrawals), portfolio diversification (including factor diversification) is immensely important.
Park wrote:
Mon May 20, 2019 12:29 pm
OTOH, how much does one want to invest in 3% of the total stock market? Although you're diversifying among factors in that 3%, there is a loss of diversification, when you ignore the other 97%.
This is a common misconception: diversification benefits accrue from correlation and variance, neither of which are dependent on market capitalization. A portfolio that is 50% large cap and 50% small cap is, empirically, much more diversified (not less) than a portfolio that is 97% large cap and 3% small cap.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 1:51 pm

acegolfer wrote:
Mon May 20, 2019 11:35 am
vineviz wrote:
Mon May 20, 2019 10:37 am
Image

The sources of risk can represent anything investor demands compensation to bear: that could be negative skew or positive excess kurtosis, but it could also be something more economically fundamental (Cochrane uses "recession risk" as an example, but it could be "inflation risk" or even the "social risk" of not holding the current hot/popular stocks).
ITT, many consider volatility as the only risk investors care about. Glad to see another BHer who understand the multi-dimension efficient frontier.

Diversification lowers volatility risk. True
Diversification lowers all kinds or risk. False.
Except in the multidimensional risk model (which I assume is mostly academic), value (funds) have generally had lower volatility risk and Beta risk. What is the dimension of risk that is going to be consistently higher in value funds than growth (index-value) funds?
Has it been higher?
Why is is going to be higher in the future?
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 1:53 pm

vineviz wrote:
Mon May 20, 2019 12:49 pm
This is a common misconception: diversification benefits accrue from correlation and variance, neither of which are dependent on market capitalization. A portfolio that is 50% large cap and 50% small cap is, empirically, much more diversified (not less) than a portfolio that is 97% large cap and 3% small cap.
...but less diversified than a portfolio of 50% bitcoin and 50% pot stocks (correlation and variance).
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Random Walker » Mon May 20, 2019 1:59 pm

acegolfer wrote:
Mon May 20, 2019 12:45 pm
Random Walker wrote:
Mon May 20, 2019 12:14 pm
If correlations between market and size, market and value, and size and value are all low, I don’t understand why Fama wouldn’t agree that diversifying a TSM portfolio into these factors should create a more efficient portfolio. By doing that one is further diversifying the portfolio into unique and independent sources of risk and return.

Dave
Seems your "more efficient portfolio" only considers volatility and ignores all other risks. In Fama world, there are other risks. See Cochrane's paper above to see what the efficient frontier looks like in a multi-factor model.
No I don’t view volatility as the only risk. Whether I do or not though, the same question applies. If there are multiple dimensions of equity risk or multiple equity factors, TSM would still by definition be net neutral on exposure to those factors. Is it possible Fama is not talking about individual portfolios when he says TSM is always efficient? I’m sure I’m missing something simple.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Random Walker » Mon May 20, 2019 2:11 pm

acegolfer wrote:
Mon May 20, 2019 11:35 am
vineviz wrote:
Mon May 20, 2019 10:37 am
Image

The sources of risk can represent anything investor demands compensation to bear: that could be negative skew or positive excess kurtosis, but it could also be something more economically fundamental (Cochrane uses "recession risk" as an example, but it could be "inflation risk" or even the "social risk" of not holding the current hot/popular stocks).
ITT, many consider volatility as the only risk investors care about. Glad to see another BHer who understand the multi-dimension efficient frontier.

Diversification lowers volatility risk. True
Diversification lowers all kinds or risk. False.
Why is “Diversification lowers all kinds of risk” false? Diversifying across as many unique sources of risk/return as possible lessens exposure to any one individual risk. An extreme example is taking away from equity risk to create a reinsurance position. There is no reason for reinsurance risk to be correlated with equity risk, and each lessens exposure to the other investment’s risks.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by asif408 » Mon May 20, 2019 2:23 pm

Personally, I'm in the camp that factors aren't anything special. The fact that nearly all of these factors that are focused on are investable makes me believe that, even if they did offer a long-term premium in the past, there will be no long term premium to any of them in the future. I do, believe, however, they will continue to go in and out of style, and you might be able to outperform by investing in a contrarian manner, tilting over time towards the least popular factors and away from the most popular ones. So you might outperform if your starting point begins with the factor out of favor and ends at a time it is in favor. But I think it would be a small minority of people that could successfully implement and follow that strategy.

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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 2:36 pm

pdavi21 wrote:
Mon May 20, 2019 1:51 pm
Except in the multidimensional risk model (which I assume is mostly academic), value (funds) have generally had lower volatility risk and Beta risk.
You keep repeating this, and it keeps being not right.

For two reasons, if you want to accurately evaluate the factor model you need to look at stocks and not funds.

First, typical mutual fund "style box" categories (like those employed by Morningstar, Lipper, S&P, etc.) are not based on factor exposure but on non-factor criteria. As a result, mutual funds almost always have multiple factor exposures. In fact, these style boxes aren't even necessarily mutually exclusive. The process for controlling for those differences is a little complicated and a lot data-intensive.

Second, the prediction of the pricing models isn't that small cap funds will be more risky. Instead, it is that small cap stocks will be more risky.

All that said, it is also empirically not true that small cap value funds had lower volatility than other fund categories. If you want the best fund-level comparison, the indexes you'd want are the "pure style" Russell and S&P indexes that Invesco uses. A simple equal-weighted portfolio of the six "pure value" Invesco ETFs has had an annualized standard deviation of 14.37% versus just 13.22% for the six "pure growth" EFTs.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 3:47 pm

vineviz wrote:
Mon May 20, 2019 2:36 pm
pdavi21 wrote:
Mon May 20, 2019 1:51 pm
Except in the multidimensional risk model (which I assume is mostly academic), value (funds) have generally had lower volatility risk and Beta risk.
You keep repeating this, and it keeps being not right.

For two reasons, if you want to accurately evaluate the factor model you need to look at stocks and not funds.

First, typical mutual fund "style box" categories (like those employed by Morningstar, Lipper, S&P, etc.) are not based on factor exposure but on non-factor criteria. As a result, mutual funds almost always have multiple factor exposures. In fact, these style boxes aren't even necessarily mutually exclusive. The process for controlling for those differences is a little complicated and a lot data-intensive.

Second, the prediction of the pricing models isn't that small cap funds will be more risky. Instead, it is that small cap stocks will be more risky.

All that said, it is also empirically not true that small cap value funds had lower volatility than other fund categories. If you want the best fund-level comparison, the indexes you'd want are the "pure style" Russell and S&P indexes that Invesco uses. A simple equal-weighted portfolio of the six "pure value" Invesco ETFs has had an annualized standard deviation of 14.37% versus just 13.22% for the six "pure growth" EFTs.
It is true for VIVAX/VIGRX and VISVX/VISGX and VMVIX/VMGIX over a longer time interval (since inception). I keep repeating it because it's true.

EDIT: Nice touch with the monthly re-balancing...It's not that value has been less volatile, it's also that is hasn't been more volatile. 13-14% volatility is just noise. EM value is more volatile than US growth, for example, because of the EM vs US, not the value vs growth.

EDIT2: with Russell only, Value is slightly less volatile. So Index mattered more than value/growth in your example.
Last edited by pdavi21 on Mon May 20, 2019 4:09 pm, edited 5 times in total.
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by nisiprius » Mon May 20, 2019 3:50 pm

Park wrote:
Mon May 20, 2019 12:29 pm
My greatest fear as an investor is a secular bear market. How can one mitigate the risk of a secular bear market?
By investing less of one's portfolio in the stock market.

It's so simple and so obvious, but it shouldn't be overlooked. It's effective. It's reliable.

I don't think you can get the equity risk premium without really taking the risk. The stock market crashes from time to time. When it does, I expect my stocks to crash right along with it.

I am honestly unsure whether or not it is possible to make pare a little bit off the risk without reducing return. Like having the equity portion of your portfolio drop 47% when Total Stock drops 52%. Maybe it is, maybe it isn't. But at best it's paring, not chopping.
Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness; Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery.

pdavi21
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by pdavi21 » Mon May 20, 2019 4:05 pm

vineviz wrote:
Mon May 20, 2019 2:36 pm
For two reasons, if you want to accurately evaluate the factor model you need to look at stocks and not funds.

First, typical mutual fund "style box" categories (like those employed by Morningstar, Lipper, S&P, etc.) are not based on factor exposure but on non-factor criteria. As a result, mutual funds almost always have multiple factor exposures. In fact, these style boxes aren't even necessarily mutually exclusive. The process for controlling for those differences is a little complicated and a lot data-intensive.

Second, the prediction of the pricing models isn't that small cap funds will be more risky. Instead, it is that small cap stocks will be more risky.
Because we all invest in long-short funds and individual securities on Bogleheads.org

Which value funds do you invest in that have been meaningfully and measurably more risky (either in terms of volatility or Beta or your choice of meaningful/measurable risk factor) than a market cap weighted fund of the remaining stocks in the underlying index?
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

Park
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Park » Mon May 20, 2019 4:24 pm

nisiprius wrote:
Mon May 20, 2019 3:50 pm
Park wrote:
Mon May 20, 2019 12:29 pm
My greatest fear as an investor is a secular bear market. How can one mitigate the risk of a secular bear market?
By investing less of one's portfolio in the stock market.

It's so simple and so obvious, but it shouldn't be overlooked. It's effective. It's reliable.

I don't think you can get the equity risk premium without really taking the risk. The stock market crashes from time to time. When it does, I expect my stocks to crash right along with it.

I am honestly unsure whether or not it is possible to make pare a little bit off the risk without reducing return. Like having the equity portion of your portfolio drop 47% when Total Stock drops 52%. Maybe it is, maybe it isn't. But at best it's paring, not chopping.
In the secular bear market from 1966 to 1981, bonds did not mitigate the risk. After inflation, expenses and taxes, I'm not certain that I consider bonds an investment vehicle. However, they are an excellent way to mitigate the risk of cyclical bear markets through hedging.

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vineviz
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 4:26 pm

pdavi21 wrote:
Mon May 20, 2019 4:05 pm
Because we all invest in long-short funds and individual securities on Bogleheads.org
Okay, but that doesn't magically make a flawed analysis useful.

It's possible to either make a well-reasoned analysis of the relative risk of factors or to refrain from characterizing that relative risk until you have to tools to do it correctly.
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

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vineviz
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by vineviz » Mon May 20, 2019 4:28 pm

pdavi21 wrote:
Mon May 20, 2019 3:47 pm
It is true for VIVAX/VIGRX and VISVX/VISGX and VMVIX/VMGIX over a longer time interval (since inception). I keep repeating it because it's true.
It's like you're not even trying to understand why this kind of comparison makes no sense. Did you read my explanation?
"Far more money has been lost by investors preparing for corrections than has been lost in corrections themselves." ~~ Peter Lynch

Park
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Re: Factor ETFs For Diversification Or “Diworsification”

Post by Park » Mon May 20, 2019 4:30 pm

Random Walker wrote:
Mon May 20, 2019 2:11 pm
acegolfer wrote:
Mon May 20, 2019 11:35 am
vineviz wrote:
Mon May 20, 2019 10:37 am
Image

The sources of risk can represent anything investor demands compensation to bear: that could be negative skew or positive excess kurtosis, but it could also be something more economically fundamental (Cochrane uses "recession risk" as an example, but it could be "inflation risk" or even the "social risk" of not holding the current hot/popular stocks).
ITT, many consider volatility as the only risk investors care about. Glad to see another BHer who understand the multi-dimension efficient frontier.

Diversification lowers volatility risk. True
Diversification lowers all kinds or risk. False.
Why is “Diversification lowers all kinds of risk” false? Diversifying across as many unique sources of risk/return as possible lessens exposure to any one individual risk. An extreme example is taking away from equity risk to create a reinsurance position. There is no reason for reinsurance risk to be correlated with equity risk, and each lessens exposure to the other investment’s risks.

Dave
About investing in alternatives, you're making two bets. To some extent, both bets have to work for investing in alternatives to make sense. The first bet is on the risk premia associated with alternatives. The second bet is on active management. Historically, the second bet hasn't gone well for investors.

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