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An engaging introduction to factor investing

Whether you call it factor investing, chasing the return premiums – or you use the once-trendy but now sounding increasingly like walking into a bar and declaring “Hey daddy-o, I’ll have a Babycham” term Smart Beta – trying to get an edge by exploiting biases in the market remains controversial.

A few hedge funds do it to great effect.

Others flounder.

Among passive investors the debate is if anything fiercer.

Indeed the idea of a passive investor pursuing a specific ’tilt’ to try to beat the market smacks some as a contradiction in terms.

I’m not one of those people – my definition of ‘passive’ is wider than most – but plenty of big guns have had a shot.

Vanguard founder Jack Bogle says:

“Smart beta is stupid; there’s no such thing. It’s an idiotic phrase.

Quoting Shakespeare, I guess: It’s a tale told by an idiot, full of sound and fury, signifying nothing.

It’s just another way of saying, “I know I’m going to be above average.”

Active managers are just trying to come back and say there is a better way to index, when they know damn well there isn’t a better way.”

I don’t think Jack’s a fan.

Everything but the Krypton Factor

One inevitable hurdle with factor investing is it takes a simple if weird idea – that by just buying the market and not paying anyone to try to do better, you probably will do better – and obfuscates it to the n-th degree.

That’s not appealing to the passive investing mindset.

For example, we’ve covered most of the return premiums on Monevator

…yet I suspect only the geekiest2 of readers have read them all in full.

Even after explaining how to build a risk factor portfolio, my own co-blogger The Accumulator then wondered aloud whether it was really worth it.

Confusing stuff.

Video on factor investing

Still is your curiosity piqued?

Naturally I’d be delighted if you read all our articles on return premium. (I suspect they’re feeling a little lonely).

But you could start instead by watching this interview with Cliff Asness, the founder of AQR Capital Management and a student of efficient market titan Eugene Fama.

Mr. Asness covers most of the bases and gives his views as to why these factors might exist – but he does it with the accent of a wise-cracking gangster from a 1950s crime flick.

I find him very personable:

Just don’t be scared when the interviewer says:

“Now, when I read the very latest papers on risk, let me tell you what I see.

I see talk of the third moment of probability distributions, the fifth moment, words like coskewness, terms like the U‑shaped pricing kernel, and talk of the volatility of volatility.

I’m just waiting on the paper on the volatility of the volatility of volatility.”

…because Asness waves all that away.

There’s also a full transcript on Medium.

Finally, for the other side of the argument you can read our own Lars Kroijer explaining why everything except a total market tracker is hokum in his view.

  1. This one is not yet accepted by the grand seers of the Chicago School of Finance. []
  2. From one investing geek to any others out there. []

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{ 6 comments… add one }
  • 1 gadgetmind November 24, 2015, 1:46 pm

    > volatility of the volatility of volatility

    Position, velocity, acceleration, jerk, jounce, snap, crackle and pop! You can keep on piling on the derivatives as long as you like, but it rapidly starts to tell you less and less.

    (See wikipedia article on jounce if you don’t know what I’m on about!)

  • 2 M from There's Value November 24, 2015, 2:02 pm

    It’s stuff like this that pushes me ever more into agreeing with Lars’ point on just buying a total market tracker and being done with it… along with a few carefully chosen ITs and individual stocks… and even fewer active funds, oh God help me I’m slipping down that slope already!

  • 3 Joseph Beckenbach November 24, 2015, 2:29 pm

    Maybe it’s the researcher training in me that’s going off right now. An excess of obfuscation signals from the speaker either “I can’t explain it and don’t want you to know that” or “I want to impress you and scare you off from asking any serious questions”.

    Both are deal-killing red flags for me as an investor.

  • 4 @algernond November 24, 2015, 4:58 pm

    It’s too bothersome for me getting individual factor ETF’s/funds. The iShares World Multfactor ETF (IFSW) looks interesting though, but it’s so expensive (0.5%), so would really need to be convinced it’s be worth it….

  • 5 Gregory November 24, 2015, 6:53 pm

    Warren Buffett said in 1985, “I have seen no trend toward value investing in the 35 years I’ve practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult.”

    The secret of the premiums is time. It can underperform for a long time so weak hands give up.

  • 6 tom November 26, 2015, 4:47 pm

    Thanks for the Asness transcript link – very interesting. There are some good links to papers he’s written – my favourite was ‘My Top 10 Peeves’ which is both funny and wise.

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