Question for Swedroe - Black Swans book

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305pelusa
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Question for Swedroe - Black Swans book

Post by 305pelusa » Sun Dec 01, 2019 9:08 pm

Hello,
I have been reading the book and came across something I don't understand. It's on page 60. The information is freely available so I hope it's ok to post this small section here. If not, I will change this OP.

The author shows the following returns
S&P 500/DFA US SC/ DFA SCV/ Equal-Weighted (1/3rd of each of the 3)
1998: +28.6/-5.5/-7.3/5.3
2001: -11.9/12.7/22.7/7.8

Authors then conclude something to the extent of "note how volatile the returns of these various funds are. But once mixed together, the volatility is damped because of the low and even negative correlation of size and value with beta. This simple example shows the benefits of diversifying across factors".

But I find the above weird because, if anything, the equal weighted portfolio has less factor exposure than the DFA SCV. You'd think that if factors are offering a diversification benefit thanks to the low or negative correlation (which is the point of this page), the example should show the DFA SCV fund having the least volatile results.

Thoughts? 0_o

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Sun Dec 01, 2019 9:50 pm

305,
That is something that has made me think twice at times too. But market, size, and value are each independent RISK factors. Size and value are additional risk factors and SV is just plain more risky than S&P 500. Yes, DFSVX is more diversified across risk factors than S&P 500, but it is also just plain more risky. Of course being more risky, it also has higher expected return. The SV fund has greater exposure to the additional risk factors than does the equal weight portfolio. The SV fund has more even exposure to the risk factors, but it also has overall greater exposure to the additional risk factors of size and value.

https://www.portfoliovisualizer.com/fac ... n3_1=33.33

https://www.portfoliovisualizer.com/fac ... sion=false

The real meaningful test I believe is to do what Larry has sometimes shown in the past. Compare two portfolios with about same expected return, say 60/40 TSM/TBM and 40/60 SCV/TBM. In that case, where you have a greater bond allocation, the portfolio SD is decreased significantly while expected return is pretty constant.

https://www.portfoliovisualizer.com/bac ... tion3_2=60

Dave

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Re: Question for Swedroe - Black Swans book

Post by 2pedals » Sun Dec 01, 2019 10:38 pm

I suggest that you send a private message to larryswedroe

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Re: Question for Swedroe - Black Swans book

Post by klaus14 » Mon Dec 02, 2019 12:27 am

Random Walker wrote:
Sun Dec 01, 2019 9:50 pm


The real meaningful test I believe is to do what Larry has sometimes shown in the past. Compare two portfolios with about same expected return, say 60/40 TSM/TBM and 40/60 SCV/TBM. In that case, where you have a greater bond allocation, the portfolio SD is decreased significantly while expected return is pretty constant.

https://www.portfoliovisualizer.com/bac ... tion3_2=60

Dave
Actually, 47/53 SCV/TBM seems to give the same return but with higher std. see

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Re: Question for Swedroe - Black Swans book

Post by Shallowpockets » Mon Dec 02, 2019 11:05 am

This is a true BH question. Much ado about nothing.

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 11:38 am

Random Walker wrote:
Sun Dec 01, 2019 9:50 pm
305,
That is something that has made me think twice at times too. But market, size, and value are each independent RISK factors. Size and value are additional risk factors and SV is just plain more risky than S&P 500. Yes, DFSVX is more diversified across risk factors than S&P 500, but it is also just plain more risky. Of course being more risky, it also has higher expected return. The SV fund has greater exposure to the additional risk factors than does the equal weight portfolio. The SV fund has more even exposure to the risk factors, but it also has overall greater exposure to the additional risk factors of size and value.

https://www.portfoliovisualizer.com/fac ... n3_1=33.33

https://www.portfoliovisualizer.com/fac ... sion=false

The real meaningful test I believe is to do what Larry has sometimes shown in the past. Compare two portfolios with about same expected return, say 60/40 TSM/TBM and 40/60 SCV/TBM. In that case, where you have a greater bond allocation, the portfolio SD is decreased significantly while expected return is pretty constant.

https://www.portfoliovisualizer.com/bac ... tion3_2=60

Dave
I thought the example was trying to show that adding more uncorrolated risk doesn't actually increase volatility. But the caveat seems to be "up to a point".

It just seemed like an argument where had SCV had the results of the EW portfolio, he would just show the first 3 funds and conclude "the SCV had the most risk exposure and least volatile results". But it felt like because it didn't, he added the 4th, Equal Weighted one, and concluded the same thing 0_o
It also confused me because it had the SC fund but no LCV fund. So the EW portfolio has more of a size tilt, which I'm suspicious about. Had he added the LCV and done the EW one, would it not have shown as good of a diversification result? I'm probably overthinking it.


Any ways, I do have one more question that I didn't see the book answer and I'm hoping others (or Larry) can:
- Unlike beta, every other factors requires that someone else tilts the opposite way. But if adding factors via tilts increases returns while decreasing risk, why would any one not tilt? I thought the implication of the EMH and Sharpe's work is that the market is the efficient portfolio (and if it weren't, institutions would arbitrage until it was).. How does MFactor investing reconcile with that?

I'm talking specifically about size and value tilts and not the other factors tilts that survive due to human bias and arbitrage limits.

Thanks

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Mon Dec 02, 2019 1:55 pm

Random Walker wrote:
Sun Dec 01, 2019 9:50 pm

But market, size, and value are each independent RISK factors. Size and value are additional risk factors and SV is just plain more risky than S&P 500. Yes, DFSVX is more diversified across risk factors than S&P 500, but it is also just plain more risky. Of course being more risky, it also has higher expected return. The SV fund has greater exposure to the additional risk factors than does the equal weight portfolio. The SV fund has more even exposure to the risk factors, but it also has overall greater exposure to the additional risk factors of size and value.
Well said. Unfortunately, some ppl here measure risk by volatility (=stdev) alone. Adding more factors -> more diversification -> lower stdev. But they ignore that they get exposed to additional risk factors.

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Mon Dec 02, 2019 2:38 pm

I think the risk of value and small value do show up in terms of greater SD. As you note though, there are also other types of risk that don’t necessarily show up in SD. And I think SV has some of this as well in addition to its higher SD. For example the specific risk of doing especially poorly in bad times or big left tail risks. This is why I think Larry says we would expect all risky assets to have ABOUT the same Sharpe ratio; because the Sharpe ratio only looks at SD as it’s measure of risk. This is at the limits of my knowledge. In fact, this limit to my knowledge is a big part of the reason I’ve taken so strongly to diversifying across as many independent sources of risk/return as I can. A big part of the SV tilt concept is to increase bond and thus term exposure concomitant with the equity tilt. This increases exposure to yet another uncorrelated source of risk, another move in the direction towards risk parity.

With regard to TSM always being on the efficient frontier, I really struggle with this one. In my mind I have divided the issue into an efficient market being one thing but an efficient portfolio another. I’ve asked Larry this question as well, and he assured me TSM is on the efficient frontier.

Dave

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 2:51 pm

Random Walker wrote:
Mon Dec 02, 2019 2:38 pm
I’ve asked Larry this question as well, and he assured me TSM is on the efficient frontier.

Dave
0_o So Larry says the TSM (and the S&P 500, which behaves nearly identical) are on the efficient frontier. But he also seems to be claiming that because the TSM has no factor exposure other than beta, it should be possible to create a more efficient stock portfolio with SCV tilt. In fact, that's the whole claim of the example I asked about.

So what, he says TSM is on the efficient frontier, but it's not the most efficient portfolio on the efficient frontier ?

That's fine, the question remains: Why would anyone tilt away from factors (and someone has to) if tilting to factors creates a more efficient portfolio than the TSM?

You and I have talked about this before. And I've said that I don't see how factor tilts could make a more efficient stock allocation. More efficient portfolio by allowing more term risk, sure. But not stock allocation itself.

But I think you personally do think that. And Larry clearly does also. And I don't see how that's compatible with a market where the TSM is on the efficient frontier.

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Mon Dec 02, 2019 3:37 pm

305pelusa wrote:
Mon Dec 02, 2019 2:51 pm
Random Walker wrote:
Mon Dec 02, 2019 2:38 pm
I’ve asked Larry this question as well, and he assured me TSM is on the efficient frontier.

Dave
0_o So Larry says the TSM (and the S&P 500, which behaves nearly identical) are on the efficient frontier. But he also seems to be claiming that because the TSM has no factor exposure other than beta, it should be possible to create a more efficient stock portfolio with SCV tilt. In fact, that's the whole claim of the example I asked about.

So what, he says TSM is on the efficient frontier, but it's not the most efficient portfolio on the efficient frontier ?

That's fine, the question remains: Why would anyone tilt away from factors (and someone has to) if tilting to factors creates a more efficient portfolio than the TSM?

You and I have talked about this before. And I've said that I don't see how factor tilts could make a more efficient stock allocation. More efficient portfolio by allowing more term risk, sure. But not stock allocation itself.

But I think you personally do think that. And Larry clearly does also. And I don't see how that's compatible with a market where the TSM is on the efficient frontier.
Yes. Like I said, the only way I can resolve it in my mind is a difference between an efficient market and an efficient portfolio. It’s almost starting to seem like light being both particle and wave.

With regard to someone taking the other side of the trade, that’s easier. It’s a question of preferences. Large growth companies are bigger safer companies with lower cost of capital and thus lower expected return. Some people may simply prefer that. Also, small growth companies are much like lottery tickets with low overall expected returns but the chance of big winner. Some people are willing to pay to play the lottery. Also, people may display different risk preferences. Some would say large growth companies are subject to price risk or bubble risk. The strong company with a generous P/E is at risk of its stock price taking a hit. The value company is more at risk of doing badly in bad economic times: you lose your job at the same time the stock takes a hit. So there are plenty of people, both rational and irrational, who might well take the growth side of the trade.

Dave

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 4:05 pm

Random Walker wrote:
Mon Dec 02, 2019 3:37 pm
Yes. Like I said, the only way I can resolve it in my mind is a difference between an efficient market and an efficient portfolio. It’s almost starting to seem like light being both particle and wave.
Ok so you agree with me that in the context of the entire portolio (bonds included), one could reach higher efficiency with factor tilts. But from purely a stock allocation, one cannot achieve higher efficiency via tilts past the TSM. Is that what you're saying?
Random Walker wrote:
Mon Dec 02, 2019 3:37 pm

With regard to someone taking the other side of the trade, that’s easier. It’s a question of preferences. Large growth companies are bigger safer companies with lower cost of capital and thus lower expected return. Some people may simply prefer that.
Why would any one prefer the safety of LCG companies if you could reach the same safety, at higher returns, by tilting to value because of the supposed diversification benefits?
Random Walker wrote:
Mon Dec 02, 2019 3:37 pm
Also, small growth companies are much like lottery tickets with low overall expected returns but the chance of big winner. Some people are willing to pay to play the lottery. Also, people may display different risk preferences. Some would say large growth companies are subject to price risk or bubble risk. The strong company with a generous P/E is at risk of its stock price taking a hit. The value company is more at risk of doing badly in bad economic times: you lose your job at the same time the stock takes a hit. So there are plenty of people, both rational and irrational, who might well take the growth side of the trade.
I'm unconvinced by these but I have a hard time putting a finger as to why.

How about this alternate theory Dave?
Factor tilts don't actually increase stock portfolio efficiency. That's because while they are uncorrolated, independent sources of risks, their Sharpe ratios, over the long run, are much lower than beta's such that when added to the market portfolio, the diversification benefit is somewhat counteracted by their lower Sharpes.

This makes perfect sense in the context of the EMH framework because a big conclusion from Markowitz (and not a well-known one) is that as security expected returns will depend on how much it diversifies the market portfolio. So assets that diversify it a lot (say utilities, CCFs, etc), are priced expensively, with lower expected future returns and lower Sharpes. Precisely because if they weren't, everyone would overweight them, achieving a diversification free lunch, until its expected future returns was low enough to somewhat offset their diversification properties.

Ditto for factors. This is what I have always thought about factors.

But this breakdown when you claim that factors will have similar Sharpes to the market. Because then tilting is a free lunch and everyone should do it.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Mon Dec 02, 2019 4:32 pm

305pelusa wrote:
Mon Dec 02, 2019 2:51 pm

So what, he says TSM is on the efficient frontier, but it's not the most efficient portfolio on the efficient frontier ?
I'm not Dave but I can answer that using Cochrane's paper: https://faculty.chicagobooth.edu/john.c ... 3Q99_4.pdf

In CAPM world, there's only 1 risk measured by stdev. So the efficient frontier is a 2 dimension graph, where E(r) is on y-axis, and stdev is on x-axis. Most agreed that CAPM is not perfect and moved to multifactor model.

In a multifactor model, there are non-stdev risks that investors fear. So the efficient frontier (EF) lies in a multi-dimension space. Where is MKT on this multi-dimension EF? It is on the EF. In other words, MKT is efficient. One can't increase its E(r) without sacrificing risk. How about this question? Can one lower stdev without lowering E(r)? Yes. But other non-stdev risk will increase.

This is my best attempt at summarizing page 62-63. Read the paper for more information. It also has multifactor implications for mean-variance investor (= BHs who only care about volatility risk).

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Re: Question for Swedroe - Black Swans book

Post by pdavi21 » Mon Dec 02, 2019 4:46 pm

It's a really tiny chunk of the market. If you compared it to a bunch of other similar sized chunks, you would probably find that it has a somewhat average volatility.
"We spend a great deal of time studying history, which, let's face it, is mostly the history of stupidity." -Stephen Hawking

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 4:55 pm

acegolfer wrote:
Mon Dec 02, 2019 4:32 pm
305pelusa wrote:
Mon Dec 02, 2019 2:51 pm

So what, he says TSM is on the efficient frontier, but it's not the most efficient portfolio on the efficient frontier ?
I'm not Dave but I can answer that using Cochrane's paper: https://faculty.chicagobooth.edu/john.c ... 3Q99_4.pdf

In CAPM world, there's only 1 risk measured by stdev. So the efficient frontier is a 2 dimension graph, where E(r) is on y-axis, and stdev is on x-axis. Most agreed that CAPM is not perfect and moved to multifactor model.

In a multifactor model, there are non-stdev risks that investors fear. So the efficient frontier (EF) lies in a multi-dimension space. Where is MKT on this multi-dimension EF? It is on the EF. In other words, MKT is efficient. One can't increase its E(r) without sacrificing risk. How about this question? Can one lower stdev without lowering E(r)? Yes. But other non-stdev risk will increase.

This is my best attempt at summarizing page 62-63. Read the paper for more information. It also has multifactor implications for mean-variance investor (= BHs who only care about volatility risk).
Nice paper. Will finish reading later but right off the bat, it seems like having a market beta of 1 while having exposure to other factors, should increase the Sharpe ratio. But it brings additional risks unrelated to beta. Is that correct? So the SCV fund should have, on average, higher Sharpe than the market portolio. Is that a fair summary of your post?

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Mon Dec 02, 2019 6:23 pm

305pelusa wrote:
Mon Dec 02, 2019 4:55 pm
Nice paper. Will finish reading later but right off the bat, it seems like having a market beta of 1 while having exposure to other factors, should increase the Sharpe ratio. But it brings additional risks unrelated to beta. Is that correct? So the SCV fund should have, on average, higher Sharpe than the market portolio. Is that a fair summary of your post?
I'll use FF 3-factor as an example for the multifactor model. If you add SMB and/or HML to MKT, the market factor loading won't be 1 any more by design. For example, if portfolio consists of 50% MKT, 30% SMB and 20% HML, then the loadings will be 0.5, 0.3, 0.2 by construction.

Yes, by exposing to SMB and HML, one can increase Sharpe ratio because it's possible to keep the same E(r) and lower stdev. But it will bring other risks.

Contrary to common belief, SCV is not a factor to explain asset prices. Hence it's not on the multi-dimension efficient frontier. (Read N-fund theorem for why.) Nevertheless, it can have a higher Sharpe ratio than MKT (at the expense of higher other risks).

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 6:38 pm

acegolfer wrote:
Mon Dec 02, 2019 6:23 pm
305pelusa wrote:
Mon Dec 02, 2019 4:55 pm
Nice paper. Will finish reading later but right off the bat, it seems like having a market beta of 1 while having exposure to other factors, should increase the Sharpe ratio. But it brings additional risks unrelated to beta. Is that correct? So the SCV fund should have, on average, higher Sharpe than the market portolio. Is that a fair summary of your post?
I'll use FF 3-factor as an example for the multifactor model. If you add SMB and/or HML to MKT, the market factor loading won't be 1 any more by design. For example, if portfolio consists of 50% MKT, 30% SMB and 20% HML, then the loadings will be 0.5, 0.3, 0.2 by construction.
The DFA funds from the example on page 60 have a beta of around 1.0 while having exposure to the other factors. So it's perfectly possible to maintain a beta of 1 in a stock portfolio, while adding other factor exposure.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Mon Dec 02, 2019 7:35 pm

305pelusa wrote:
Mon Dec 02, 2019 6:38 pm
acegolfer wrote:
Mon Dec 02, 2019 6:23 pm
305pelusa wrote:
Mon Dec 02, 2019 4:55 pm
Nice paper. Will finish reading later but right off the bat, it seems like having a market beta of 1 while having exposure to other factors, should increase the Sharpe ratio. But it brings additional risks unrelated to beta. Is that correct? So the SCV fund should have, on average, higher Sharpe than the market portolio. Is that a fair summary of your post?
I'll use FF 3-factor as an example for the multifactor model. If you add SMB and/or HML to MKT, the market factor loading won't be 1 any more by design. For example, if portfolio consists of 50% MKT, 30% SMB and 20% HML, then the loadings will be 0.5, 0.3, 0.2 by construction.
The DFA funds from the example on page 60 have a beta of around 1.0 while having exposure to the other factors. So it's perfectly possible to maintain a beta of 1 in a stock portfolio, while adding other factor exposure.
The equation is DFA = rf + 1.0 (MKT-rf) + b SMB + c HML + e. To be on the EF, the e (error) term must be 0 (in other words, R^2 = 100%).

"now every point on the multifactor efficient frontier can be reached by some combination of three multifactor efficient funds" pg 63

I doubt this is the case for DFA. Correct me, if wrong. Is DFA fund a combination of MKT, SMB and HML?

In sum, a ptf can have beta of 1 and some loadings on other factors. But it doesn't necessarily mean it's efficient.

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Mon Dec 02, 2019 9:05 pm

acegolfer wrote:
Mon Dec 02, 2019 7:35 pm
305pelusa wrote:
Mon Dec 02, 2019 6:38 pm
acegolfer wrote:
Mon Dec 02, 2019 6:23 pm
305pelusa wrote:
Mon Dec 02, 2019 4:55 pm
Nice paper. Will finish reading later but right off the bat, it seems like having a market beta of 1 while having exposure to other factors, should increase the Sharpe ratio. But it brings additional risks unrelated to beta. Is that correct? So the SCV fund should have, on average, higher Sharpe than the market portolio. Is that a fair summary of your post?
I'll use FF 3-factor as an example for the multifactor model. If you add SMB and/or HML to MKT, the market factor loading won't be 1 any more by design. For example, if portfolio consists of 50% MKT, 30% SMB and 20% HML, then the loadings will be 0.5, 0.3, 0.2 by construction.
The DFA funds from the example on page 60 have a beta of around 1.0 while having exposure to the other factors. So it's perfectly possible to maintain a beta of 1 in a stock portfolio, while adding other factor exposure.
The equation is DFA = rf + 1.0 (MKT-rf) + b SMB + c HML + e. To be on the EF, the e (error) term must be 0 (in other words, R^2 = 100%).

"now every point on the multifactor efficient frontier can be reached by some combination of three multifactor efficient funds" pg 63

I doubt this is the case for DFA. Correct me, if wrong. Is DFA fund a combination of MKT, SMB and HML?

In sum, a ptf can have beta of 1 and some loadings on other factors. But it doesn't necessarily mean it's efficient.
I'm not asking if it's Multifactor efficient, or even on the regular efficient frontier. Just if its Sharpe will be higher or lower than TSM.

That paper seems to imply it would have higher Sharpe, but "paid for" by opening yourself to other unrelated risks no?

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Mon Dec 02, 2019 9:23 pm

305pelusa wrote:
Mon Dec 02, 2019 9:05 pm
I'm not asking if it's Multifactor efficient, or even on the regular efficient frontier. Just if its Sharpe will be higher or lower than TSM.

That paper seems to imply it would have higher Sharpe, but "paid for" by opening yourself to other unrelated risks no?
Is SCV Sharpe ratio higher than TSM? Certainly possible. I don't know the ticker for your DFA fund. But VBR's Sharpe is lower than VTI's, according to M*.
https://www.morningstar.com/etfs/arcx/vbr/risk
https://www.morningstar.com/etfs/arcx/vti/risk

Yes, if a fund has higher Sharpe ratio than MKT, then it's "paid for" by other risks, "under" the asset pricing model/EMH framework. Of course, some ppl may argue that asset pricing model/EMH is false and there are free lunch.

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Re: Question for Swedroe - Black Swans book

Post by larryswedroe » Tue Dec 03, 2019 9:07 am

Hope this helps

IF you believe markets efficient than must believe all risk assets have similar risk-adjusted returns, not similar returns, but similar risk-adjusted returns. Now risk isn't just SD, it includes things like liquidity risk and skewness and kurtosis, and when risks show up-does it correlate with labor capital. Assets whose risks tend to show up in bad times demand larger risk premium. (Note we know market is not perfectly efficient or we would not have all these anomalies like lottery stocks with awful returns, like small growth with low profits and high investment which have underperformed tbills).

If SV had higher risk adjusted expected returns capital would flow out into TSM and prices would move to equilibrium. So if SV riskier,it must have higher expected returns to compensate. But not higher risk adjusted returns.

So SV risk-adjusted expected return must be similar to that of TSM or S or V or any other risk asset, including things like reinsurance, selling volatility, or REITS, etc. And that is in fact what the evidence shows. They all tend to have Sharpe's of about .3 to .5 after implementation costs. And again SR is not only measure of risk. So example if you get a liquidity premium in an asset and don't need liquidity then for you it is free lunch to some extent. So an asset might show high SR because there are other risks, like liquidity. And they should be compensated for. Good example is LENDX which has had very high SR, but that doesn't account for the illiquidity.

One last point, if markets inefficient, as behavioralists believe than SV has higher risk adjusted returns than TSM as do all value strategies, and limits to arbitrage prevent market from correcting mispricings.

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Tue Dec 03, 2019 9:39 am

Hi Larry,
I’ve been struggling with this issue all night. Have been struggling with how to formulate the question. So, it makes sense to me that in efficient market Size and Value, which are uncorrelated, would each have similar Sharpe ratio. Also makes sense to me that SV would have similar Sharpe ratio because the market prices risk. But this is where my head starts spinning a bit. If I combine individual S and V funds into a portfolio, the portfolio Sharpe should be better than that of the individual components. Yet the individual components combined into one investable SV fund have the same expected Sharpe 0.3-0.5. Is the issue what is the basic investable units of the portfolio? I know in general for other reasons it is better to, as much as possible, combine styles and asset classes into a single fund when possible. But this seems to create an argument pointing towards maximal slicing and dicing in a portfolio.
To amplify my question, take the AQR Style Premia fund which is diversified across something like 4 styles and 4 or more asset classes. Do I expect this fund to have about same Sharpe ratio as any other investable asset? If I create a portfolio of the individual styles and asset classes, I think there would be a dramatic improvement in the portfolio’s Sharpe compared to the individual components. Thanks for your patience on this.

Dave

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 9:54 am

Random Walker wrote:
Tue Dec 03, 2019 9:39 am

So, it makes sense to me that in efficient market Size and Value, which are uncorrelated, would each have similar Sharpe ratio. Also makes sense to me that SV would have similar Sharpe ratio because the market prices risk.
Not Larry

Sharpe ratio only considers stdev as a risk measurement. A multi-factor model doesn't imply each factor (or any portfolio on multi-dimension EF) have the same Sharpe ratio.

If you don't get this, then imagine a simple CAPM world, where only stdev matters. There are many efficient portfolios on the EF. But only the tangency portfolio has the highest Sharpe ratio.

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Tue Dec 03, 2019 10:00 am

Hi ace,
Yes I understand that there are many types of risk, but I guess my question boils down to whether, when generating portfolios, is it potentially better (at least to some extent) to keep the individual sources of risk/return separate within the portfolio? I know we generally combine them as much as possible because we don’t want one fund buying an asset and another selling the same asset.

Dave

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 10:03 am

Random Walker wrote:
Tue Dec 03, 2019 10:00 am
Hi ace,
Yes I understand that there are many types of risk, but I guess my question boils down to whether, when generating portfolios, is it potentially better (at least to some extent) to keep the individual sources of risk/return separate within the portfolio? I know we generally combine them as much as possible because we don’t want one fund buying an asset and another selling the same asset.

Dave
"separate within" Not sure what you mean by this. Can you elaborate?

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Tue Dec 03, 2019 10:15 am

Perhaps my question is only theoretical. I know practically it is better to combine factors within a single fund. But I was asking if there is potentially some improvement in portfolio efficiency if within a portfolio I have for example separate small and value funds as opposed to a single SV fund.

Dave

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 10:30 am

Random Walker wrote:
Tue Dec 03, 2019 9:39 am
Hi Larry,
I’ve been struggling with this issue all night. Have been struggling with how to formulate the question. So, it makes sense to me that in efficient market Size and Value, which are uncorrelated, would each have similar Sharpe ratio. Also makes sense to me that SV would have similar Sharpe ratio because the market prices risk. But this is where my head starts spinning a bit. If I combine individual S and V funds into a portfolio, the portfolio Sharpe should be better than that of the individual components. Yet the individual components combined into one investable SV fund have the same expected Sharpe 0.3-0.5. Is the issue what is the basic investable units of the portfolio? I know in general for other reasons it is better to, as much as possible, combine styles and asset classes into a single fund when possible. But this seems to create an argument pointing towards maximal slicing and dicing in a portfolio.
To amplify my question, take the AQR Style Premia fund which is diversified across something like 4 styles and 4 or more asset classes. Do I expect this fund to have about same Sharpe ratio as any other investable asset? If I create a portfolio of the individual styles and asset classes, I think there would be a dramatic improvement in the portfolio’s Sharpe compared to the individual components. Thanks for your patience on this.

Dave
Dave you've managed to ask EXACTLY what I've been trying to ask. And it is extremely nebulous and difficult to explain but based on your post, you and I are on the same page. I also have trouble formulating the question.

If a SCV and a TSM fund have similar risk-adjusted returns, but a portfolio with half of each will have higher, then couldn't someone make a fund that includes the securities of each in 50/50 proportion, and then THAT fund will have a higher Sharpe than the market? That can't be because then money would flow into that new "asset class" (call it Barbell Midcap Valueish) until it didn't.

In a similar vein: Swedroe claims a MF fund (with MOM, beta, quality, size, value, etc) will have higher Sharpe than TSM right? Because of the whole diversification of factors. But SCV IS a Multifactor fund when you think about it. So then perhaps Multifactor funds (like VFMF) will NOT have higher Sharpes. So then why would a portfolio made up of its parts have a higher Sharpe (which is what Page 60 seems to say)?

Something is not adding up here and I think you notice it too.

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Re: Question for Swedroe - Black Swans book

Post by larryswedroe » Tue Dec 03, 2019 10:32 am

Random
This gets pretty complicated because when simply tilting to say SV that means you add some unique risks, but remember that the SV stocks have high betas. In CAPM world for example, DFSVX has market beta of about 1.2. So that is taking more beta risk than market while adding other sources of risk. You get the real benefits from adding more unique sources like using the higher expected returns to lower exposure to beta and add more safe bonds, and there you get a big benefit not only due to lower correlation but also because the tendency is for very low correlation of safe bonds to risky stocks to turn sharply negative during bear equity markets. So that pulls in left tail more than right tail (correlation is low positive in bull markets). So have to look at not only correlations and volatility (covariance) but also when the correlations tend to rise or fall (correlations are long term averages).

Also have issue of is value a behavioral story, or at least partly one. If it is then yes simply tilting will lead to more efficient portfolio, at least ex ante.

As to AQR, yes the correlations being low to negative leads to higher expected SR of the fund than for individual components.

For those interested in there is a good paper by Blitz etal on long only factor portfolios, containing good news, showing don't have to be long short.
https://papers.ssrn.com/sol3/papers.cfm ... id=3493305
I just finished write up after discussing with authors and will eventually get it posted on one of the three sites I post for. Likely Advisor Perspectives

Best wishes
Larry

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 10:41 am

acegolfer wrote:
Tue Dec 03, 2019 10:03 am
Random Walker wrote:
Tue Dec 03, 2019 10:00 am
Hi ace,
Yes I understand that there are many types of risk, but I guess my question boils down to whether, when generating portfolios, is it potentially better (at least to some extent) to keep the individual sources of risk/return separate within the portfolio? I know we generally combine them as much as possible because we don’t want one fund buying an asset and another selling the same asset.

Dave
"separate within" Not sure what you mean by this. Can you elaborate?
Imagine the following funds:
TSM; a MCV fund light on value; a SCV fund

Swedroe says they all should have similar Sharpes (call it X). But combining TSM and a SCV fund in a portfolio will have higher expected Sharpe as per example page 60 (call it Y > X). But the MCV fund has, say, the exact same total factor exposure as 50/50 TSM/SCV. So it has the same expected returns (same factor exposure) with a Sharpe of X while a portfolio of TSM/SCV has a Sharpe of Y.

So 50/50 TSM/SCV has lower St Dev than MCV. Which I didn't think would be the case. I assumed if you have two different portfolios, all that mattered were the factor exposures: those would determine the return AND the risk.

So the implication Dave makes is that instead of using Multifactor funds that already include all the factor exposure you want in it (the MCV), it's better to slice the portfolio as much as possible into more concentrated funds (50/50 TSM/SCV) because apparently that gives higher Sharpe.

That doesn't make any sense to me

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 10:46 am

larryswedroe wrote:
Tue Dec 03, 2019 10:32 am

As to AQR, yes the correlations being low to negative leads to higher expected SR of the fund than for individual components.
If that fund had higher Sharpe than its individual components, then wouldn't money flow into it until it didn't?

In other words:
Why would a MF fund that targets 4+ factors (AQR) achieve higher expected Sharpe than TSM, but one that exposes itself to only 3 factors (SCV) not have it too?

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Re: Question for Swedroe - Black Swans book

Post by larryswedroe » Tue Dec 03, 2019 10:48 am

The AQR case is not an equity fund, it's multi factor across stocks, bonds, commodities and currencies, and there is basically no market beta exposure. When you add SV to TSM you still have big part of return of SV explained by market beta, say 2/3 or more because beta is >1. The big benefit as I have said comes from using the higher expected return to LOWER market beta and add much different risk, like safe bonds.

And of course cash flows (popularity) can alter things. And make any asset if too popular inefficient (overvalued) and vice versa. We know markets are not perfectly efficient or we would not have lottery stocks or bubbles like 2000 in growth stocks which was clearly, ex-ante a bubble.

But yes, bottom line is IMO, one should consider that all risks considered all risky assets should have SIMILAR risk adjusted returns. Not the same because there are limits to arbitrage and preferences that prevent perfect arbitrage. And again, Sharpe ratios not the perfect measure of risk adjusted returns as one poster pointed out. It assumes normal distributions (which is not the case) and ignores risks other than SD, like illiquidity.

And combining unique risks can improve portfolio efficiency through diversification benefits, dampening volatility of the portfolio.
Last edited by larryswedroe on Tue Dec 03, 2019 10:59 am, edited 1 time in total.

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 10:52 am

larryswedroe wrote:
Tue Dec 03, 2019 10:48 am
The AQR case is not an equity fund, it's multi factor across stocks, bonds, commodities and currencies, and there is basically no market beta exposure
Ok fair. So one that is all equity and with beta of about 1 (say, something like LRGF) has an expected Sharpe similar to TSM?

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 11:07 am

305pelusa wrote:
Tue Dec 03, 2019 10:46 am
If that fund had higher Sharpe than its individual components, then wouldn't money flow into it until it didn't?
Your statement would be true in Markowitz world, where all investors are mean-variance investors. Only in such world, all investors will go after the highest Sharpe ratio fund.

However, in a multi-factor model, volatility (measured by Stdev) is not the only risk investors fear. So some may go after lower Sharpe ratio fund such as TSM with higher Stdev but with lower other risks.

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Re: Question for Swedroe - Black Swans book

Post by larryswedroe » Tue Dec 03, 2019 11:08 am

LRGF, with value and MOM having negative correlations and similar risk-adjusted returns, and low correlations of the other factors (e.g, quality with market beta) should get some benefit, but the fund has very low loading on each of them,

Also adding to acegolfer's points, there are limits to arbtirage and preferences by individuals for some risks over others, and liquidity constraints, that all prevent market from being perfectly "efficient. That's in addition to the point about there being other risks besides SD which I mentioned. If markets were as efficient as some think then how do you explain the god awful performance of a whole variety of "lottery stocks" as I mentioned. Which means by the way that TSM cannot be the most efficient portfolio because it includes these stocks. One could do better simply by excluding them.

Hopefully that helps
Sorry don't have more time to spend on this
Last edited by larryswedroe on Tue Dec 03, 2019 11:12 am, edited 1 time in total.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 11:10 am

305pelusa wrote:
Tue Dec 03, 2019 10:41 am

Swedroe says they all should have similar Sharpes (call it X).
I remember him saying all should have similar risk adjusted expected return. I agree with this. But did he also say "they all should have similar Sharpes"? If so, I fully disagree.

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Re: Question for Swedroe - Black Swans book

Post by larryswedroe » Tue Dec 03, 2019 11:17 am

Okay one more. I believe I have made clear that they should have similar risk-adjusted returns and that the SR is NOT the perfect measure of risk and explained why. It's possible in trying to answer a question I may have said similar SR, and that is pretty true for most public broadly diversified equity portfolios. But once you get to stocks with higher skewness and kurtosis and less liquidity and where limits to arbitrage can play a role (like in microcaps especially) then not as true. And certainly not true for illiquid investments.

Again, SR is ONE measure of risk adjusted returns but has limitations. Fine for similar investments.
Larry

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 11:18 am

acegolfer wrote:
Tue Dec 03, 2019 11:10 am
305pelusa wrote:
Tue Dec 03, 2019 10:41 am

Swedroe says they all should have similar Sharpes (call it X).
I remember him saying all should have similar risk adjusted expected return. I agree with this. But did he also say "they all should have similar Sharpes"? If so, I fully disagree.
0_o
larryswedroe wrote:
Tue Dec 03, 2019 9:07 am

So SV risk-adjusted expected return must be similar to that of TSM or S or V or any other risk asset, including things like reinsurance, selling volatility, or REITS, etc. And that is in fact what the evidence shows. They all tend to have Sharpe's of about .3 to .5 after implementation costs.
He's saying they have similar risk-adjusted returns and claims the evidence shows it, and quotes the Sharpe.

Do you see now why I'm so confused lol?

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 11:25 am

larryswedroe wrote:
Tue Dec 03, 2019 11:17 am
Okay one more. I believe I have made clear that they should have similar risk-adjusted returns and that the SR is NOT the perfect measure of risk and explained why. It's possible in trying to answer a question I may have said similar SR, and that is pretty true for most public broadly diversified equity portfolios. But once you get to stocks with higher skewness and kurtosis and less liquidity and where limits to arbitrage can play a role (like in microcaps especially) then not as true. And certainly not true for illiquid investments.

Again, SR is ONE measure of risk adjusted returns but has limitations. Fine for similar investments.
Larry
Ok so in terms of risk-adjusted returns, TSM, SCV, SC and an equal weighting of all have the same risk-adjusted returns.

In terms of Sharpe specifically, then SCV has the highest Sharpe of them all (and TSM last). And that's made up by the additional risks aside from St Dev itself yes? Cause that's what I've been saying for a while in this thread but got really mixed up by your comment here:
larryswedroe wrote:
Tue Dec 03, 2019 9:07 am

So SV risk-adjusted expected return must be similar to that of TSM or S or V or any other risk asset, including things like reinsurance, selling volatility, or REITS, etc. And that is in fact what the evidence shows. They all tend to have Sharpe's of about .3 to .5 after implementation costs.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 11:26 am

305pelusa wrote:
Tue Dec 03, 2019 11:18 am
acegolfer wrote:
Tue Dec 03, 2019 11:10 am
305pelusa wrote:
Tue Dec 03, 2019 10:41 am

Swedroe says they all should have similar Sharpes (call it X).
I remember him saying all should have similar risk adjusted expected return. I agree with this. But did he also say "they all should have similar Sharpes"? If so, I fully disagree.
0_o
larryswedroe wrote:
Tue Dec 03, 2019 9:07 am

So SV risk-adjusted expected return must be similar to that of TSM or S or V or any other risk asset, including things like reinsurance, selling volatility, or REITS, etc. And that is in fact what the evidence shows. They all tend to have Sharpe's of about .3 to .5 after implementation costs.
He's saying they have similar risk-adjusted returns and claims the evidence shows it, and quotes the Sharpe.

Do you see now why I'm so confused lol?
Difference between 0.3 to 0.5 in Sharpe ratio in my view is significant. Using 15% Stdev, 0.2 difference corresponds to 0.2 * 0.15 = 3% annualized return difference. Perhaps, 3% E(r) difference can be trivial to Larry and you.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 11:30 am

305pelusa wrote:
Tue Dec 03, 2019 11:25 am
In terms of Sharpe specifically, then SCV has the highest Sharpe of them all (and TSM last).
Any source?

M* says otherwise for DFSVX vs VTSAX
https://www.morningstar.com/funds/xnas/dfsvx/quote
https://www.morningstar.com/funds/xnas/vtsax/quote

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 11:42 am

acegolfer wrote:
Tue Dec 03, 2019 11:26 am
305pelusa wrote:
Tue Dec 03, 2019 11:18 am
acegolfer wrote:
Tue Dec 03, 2019 11:10 am
305pelusa wrote:
Tue Dec 03, 2019 10:41 am

Swedroe says they all should have similar Sharpes (call it X).
I remember him saying all should have similar risk adjusted expected return. I agree with this. But did he also say "they all should have similar Sharpes"? If so, I fully disagree.
0_o
larryswedroe wrote:
Tue Dec 03, 2019 9:07 am

So SV risk-adjusted expected return must be similar to that of TSM or S or V or any other risk asset, including things like reinsurance, selling volatility, or REITS, etc. And that is in fact what the evidence shows. They all tend to have Sharpe's of about .3 to .5 after implementation costs.
He's saying they have similar risk-adjusted returns and claims the evidence shows it, and quotes the Sharpe.

Do you see now why I'm so confused lol?
Difference between 0.3 to 0.5 in Sharpe ratio in my view is significant. Using 15% Stdev, 0.2 difference corresponds to 0.2 * 0.15 = 3% annualized return difference. Perhaps, 3% E(r) difference can be trivial to Larry and you.
Does it matter? 0_o the point was that Larry was clearly linking Sharpe as the "risk-adjusted" benchmark.
acegolfer wrote:
Tue Dec 03, 2019 11:30 am
305pelusa wrote:
Tue Dec 03, 2019 11:25 am
In terms of Sharpe specifically, then SCV has the highest Sharpe of them all (and TSM last).
Any source?

M* says otherwise for DFSVX vs VTSAX
https://www.morningstar.com/funds/xnas/dfsvx/quote
https://www.morningstar.com/funds/xnas/vtsax/quote
If SCV has the same risk-adjusted return as TSM (you agree to that), and it also has other higher risks due to factor exposures (in a Multifactor world), then it must have a higher Sharpe to make up for it so its overall risk-adjusted return is similar to TSM.

I'm not using past data, just theory.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 11:51 am

305pelusa wrote:
Tue Dec 03, 2019 11:42 am
it must have a higher Sharpe to make up for it so its overall risk-adjusted return is similar to TSM.
That will be true, only if SCV is on EF. But in FF 3 factor model, SCV is not on EF. MKT, SMB, HML are.
Last edited by acegolfer on Tue Dec 03, 2019 12:49 pm, edited 2 times in total.

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 12:03 pm

305pelusa wrote:
Tue Dec 03, 2019 11:42 am
Does it matter? 0_o the point was that Larry was clearly linking Sharpe as the "risk-adjusted" benchmark.
If Larry claims similar Sharpe ratio implies same risk-adjusted expected return, then I fully disagree with him.

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 12:04 pm

acegolfer wrote:
Tue Dec 03, 2019 11:51 am
305pelusa wrote:
Tue Dec 03, 2019 11:42 am
If SCV has the same risk-adjusted return as TSM (you agree to that), and it also has other higher risks due to factor exposures (in a Multifactor world), then it must have a higher Sharpe to make up for it so its overall risk-adjusted return is similar to TSM.
That will be true only if SCV is on EF. But in FF 3 factor model, SCV is not on EF. MKT, SMB, HML are.
Whoah I don't get it lol. SCV has higher returns than TSM. Those returns come from factors whose risks do not come as St Dev. So then it's Sharpe (which is a function of the total return, now higher, and it's St Dev, still the same) should go up.

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Re: Question for Swedroe - Black Swans book

Post by Random Walker » Tue Dec 03, 2019 12:12 pm

Larry’s point above that SV funds also have slightly higher market beta is significant; emphasizes the importance of cooling off overall equity allocation when tilting to increase portfolio efficiency.

Dave

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Re: Question for Swedroe - Black Swans book

Post by acegolfer » Tue Dec 03, 2019 12:48 pm

305pelusa wrote:
Tue Dec 03, 2019 12:04 pm
acegolfer wrote:
Tue Dec 03, 2019 11:51 am
305pelusa wrote:
Tue Dec 03, 2019 11:42 am
If SCV has the same risk-adjusted return as TSM (you agree to that), and it also has other higher risks due to factor exposures (in a Multifactor world), then it must have a higher Sharpe to make up for it so its overall risk-adjusted return is similar to TSM.
That will be true only if SCV is on EF. But in FF 3 factor model, SCV is not on EF. MKT, SMB, HML are.
Whoah I don't get it lol. SCV has higher returns than TSM. Those returns come from factors whose risks do not come as St Dev. So then it's Sharpe (which is a function of the total return, now higher, and it's St Dev, still the same) should go up.
I got "only if" mixed up. Fixed.

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Re: Question for Swedroe - Black Swans book

Post by 305pelusa » Tue Dec 03, 2019 12:53 pm

acegolfer wrote:
Tue Dec 03, 2019 12:48 pm
305pelusa wrote:
Tue Dec 03, 2019 12:04 pm
acegolfer wrote:
Tue Dec 03, 2019 11:51 am
305pelusa wrote:
Tue Dec 03, 2019 11:42 am
If SCV has the same risk-adjusted return as TSM (you agree to that), and it also has other higher risks due to factor exposures (in a Multifactor world), then it must have a higher Sharpe to make up for it so its overall risk-adjusted return is similar to TSM.
That will be true only if SCV is on EF. But in FF 3 factor model, SCV is not on EF. MKT, SMB, HML are.
Whoah I don't get it lol. SCV has higher returns than TSM. Those returns come from factors whose risks do not come as St Dev. So then it's Sharpe (which is a function of the total return, now higher, and it's St Dev, still the same) should go up.
I got "only if" mixed up. Fixed.
I'm saying IF SCV has the same risk-adjusted returns as TSM, then because it has higher returns (which SR fully includes) but not commensurately higher ST Dev (because the additional factory risks don't show up as St Dev), THEN the SR will be higher. Regardless of whether SCV is on the EF or not.

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