Good reads from around the Web.
Whatever you call it – Smart Beta, factor investing, return premiums like my co-blogger The Accumulator, or “alchemy” like a cynic – trying to get an edge from bespoke passive funds is proving popular.
We’ve got mixed feelings about the trend around here.
The Accumulator does tilt for the value and size factors, for instance.
But our visiting professor of passive investing, Lars Kroijer, says investing in anything but a global tracker is irrational.
The academic literature certainly looks encouraging. Some classes of shares – labelled value, small caps, quality, low volatility, illiquidity, momentum – have previously outperformed the market, for much-debated reasons.
Some say they’re higher risk. Some say they’re anomalies. Some say some of those factors are different manifestations of the same thing. If you’re confused, then there is an entry-level interview with a quant fund manager that explains the basics on Barrons this week.
Whatever the reason for their historical outperformance though, new ETFs have made factor investing much easier.
Relatively cheap Smart Beta funds have taken factor investing from hedge funds to discount brokers. But even fans warn there are caveats.
Short-term: The Krypton factor
For one thing, the academic research flatters to deceive. Getting the higher returns found in the labs from the comfort of your own home might be harder than it looks.
Also, the premiums don’t work all the time. They can go on the blink for years.
Value shares have been in the dustbin since the financial crisis, for example. Only recently have they shown signs of their hoped-for vim and vigour.
In any single period, the divergences can be staggering. The following graph from the Financial Times this week shows how different kinds of UK small cap shares have been doing:
Stocks in the data belong to the Numis Smaller Companies Index.
Source: FT
It’s worth noting that you can’t easily buy into small cap versions of the factors charted in the graph in the UK. Just getting a vanilla small cap tracker is hard enough here.
The data is a result of academic number crunching. But the takeaway message is clear – and Professor Paul Marsh of the London Business School says the same divergence has been seen with larger companies, too.
Marketing for smart beta funds tends to point to long-term graphs. That might seem appropriate for long-term investors. But to get to the long-term, you have to stomach through a lot of short-terms.
For that reason, mixing factors in a portfolio would seem to make sense. If one factor is down in the dumps, another might thrive.
True – but how much mixing before you’ve just recreated a more costly global tracker fund?
Exactly. No wonder index fund creator Jack Bogle is skeptical.
From the blogs
Making good use of the things that we find…
Passive investing
- The most powerful force in the universe – The Irrelevant Investor
- What a lawyer learned about investing – Humble Dollar
- A logical investment strategy revisited – DIY Investor (UK)
- Too many cooks in the kitchen – The Evidence-based Investor
- Interview with Bill McNabb, Vanguard CEO [Podcast] – T.E.B.I.
Active investing
- Beware the Frightful Five – Smead Capital
- Sell Netflix, Buy Blockbuster – The Irrelevant Investor
- Is National Grid a low-risk dividend stock? [PDF] – UK Value Investor
- Cracking the currency code – Musings on Markets
- Riffing on thoughts from Charley Ellis – The Waiter’s Pad
- Brain or machine? – Investing Caffeine
- Accounts will only get you so far – The Value Perspective
Other articles
- Four reasons to buy bonds in 2017 – Peter Lazaroff
- An investing pet peeve – A Wealth of Common Sense
- Principals for a successful retirement – JP Asset Management
- Mentally ready for financial independence – Retirement Investing Today
- Investing is the ultimate collection – Power Over Life
- Eulogy to another great dad – Mr Money Mustache
- The inspiration for Trump’s speech? [Twitter, video] – Timothy Burke
Product of the week: The Telegraph says Amazon’s new Platinum Mastercard isn’t the most generous reward card around, and notes you can only spend the points you earn on the Amazon website. But let’s face it, Amazon sells everything anyway. There’s also no annual fee, and you get free money – well, a £10 gift card – on signing up.
Mainstream media money
Some links are Google search results – in PC/desktop view these enable you to click through to read the piece without being a paid subscriber of that site.1
Passive investing
- The end of active investing? [Search result, wide-ranging piece] – FT
- Vanguard cuts fees on LifeStrategy funds – Telegraph
- Do It Yourself investors still shunning passive funds [Search result] – FT
- Is the FTSE headed for a crash in 2017? – Guardian
- Struggling hedge funds still expense bonuses, bar tabs – Reuters
- How well does running Vanguard pay? – Bloomberg
Active investing
- How the UK’s biggest fund lost £717m when market was up 22% – Telegraph
- Merryn: Why I am not that into Warren Buffett [Search result] – FT
- ETFs have replaced stocks as the most actively traded assets – Bloomberg
- Another look at US asset valuations – Bloomberg
- Where is it worth paying for a stock picker? – Telegraph
A word from a broker
- Do the markets need rebalancing? – TD Direct Investing
- Lloyds shares: Buy, sell, or hold? – Hargreaves Lansdown
Other stuff worth reading
- Paying for care at home: Costs and case studies – Guardian
- Stamp duty blamed for housing ‘gridlock’ as owners stay put – Telegraph
- Five ways to make extra money from your home – ThisIsMoney
- Mortgage rates are rising faster than savings rates – Telegraph
- Owning a dog could cost you £33,000 – Guardian
- Is early retirement great? Some find it hard work – New York Times
- How Steve Jobs saved Apple and Nike with the same advice – Quartz
- The hidden value of a good night’s sleep [Search result] – FT
- UK in denial over Brexit, says Davos elite – ThisIsMoney
- Trump’s speech: American carnage [Various front pages] – BBC
Book of the week: Even those who still dispute there was more to Brexit than a clear-headed vote for national sovereignty seem to see what’s going on with the election of Donald Trump. Perhaps that’s why his sort-of biography Trump: The Art of the Deal is a bestseller again. £4.99 on Kindle and £9.99 in paperback, what else have we got to go on, bar his Twitter rants and Dr Strangelove?
Like these links? Subscribe to get them every week!
- Note some articles can only be accessed through the search results if you’re using PC/desktop view (from mobile/tablet view they bring up the firewall/subscription page). To circumvent, switch your mobile browser to use the desktop view. On Chrome for Android: press the menu button followed by “Request Desktop Site”. [↩]
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One thing that all the academic research also fails to consider is that real life is a little more complicated than all the studies. If I knew what I know now and had the products available of today I could easily see the equities portion of my investment strategy being buy VWRL followed closely by a fishing trip. Instead my portfolio is a bit of a hotch potch because:
– Before I decided passive investing was for me I listened to the hype and bought active. I’m still stuck with some of them as I now can’t sell for tax reasons. Time is healing the wounds though as they dwindle away as new money enters the portfolio and their dividends are used to buy passive.
– I lived abroad a few years ago and also considered migrating there. At the time the in thing was home bias with a decent portion of your assets so I have some of that as a legacy also.
– Vanguard UK didn’t exist when I started my investing journey.
– VWRL also didn’t exist when I started buying Vanguard (I don’t think) so I’ve ended up with VUKE, VMID, VUSA, VERX, VEUR, VJPN and VFEM to build a diversified equity portfolio. I think my annual expenses are lower but it certainly ain’t simpler keeping those balanced. To switch that lot to VWRL now would also incur trading expenses, being out of the market for a short time, buy/sell spreads and possibly some taxes.
For me value factor is not just HOPE for higher return but also to mitigate bubbles.
I’m not sure I understand where factor investing fits into the average investors portfolio.
If the aims of it are to try to gain an ‘edge’ over the market, for example, deciding to back value rather than momentum then this is a market call. To make a market call assumes that the investor has an edge which may pose the question as to why you would’t let an active fund manager make that call rather than trying to do it yourself?
IMHO accounting for too many different eventualities is only going at best dilute returns or provide insignificant upside unless you are prepared to go all out and back your view 100%. I’m sticking with my general World Tracker as this already has value momentum plays in it.
The only caveat to that is that I like global smaller companies but I see these as a different asset class rather than a style factor.
I suspect passive factor investing is on a bit of a long journey, and we will have to wait for storms to pass before we have the products we need. I expect a long wait.
I enjoyed the recent book “your complete guide to factor investing” by Larry Swedroe, and before that the most excellent “a systematic approach to factor investing” by Andrew Ang. But in common with both, they make little attempt to show how to construct a practical passive portfolio from the information they present.
If anything, they caution not to try. One must alter the factor allocations too frequently, and in opposition to each other. One must be careful not to hold competing factors at the same time that nullify each other. One has to decipher what the smart fund is doing outside its marketing label- is it really momentum, or is it value and momentum? One must accept the lack of transparency of algorithm.
In the end, a low fee multi-factor etf is usually advocated. But that smells too active and opaque to me. At least for now. As far as I’ve gone is to hold a value factor etf, and as a replacement for a holding that was already inside my allocation.
A manager of a fund can’t wait for years. A small investor’s edge is patience. This is The Big Secret for the Small Investor. http://www.valuewalk.com/2016/11/notes-quotes-wealthtrack-joel-greenblatt-talks-investing/?all=1
What kind of annual fees do factor funds charge? Given they are algorithmic, they should be nearly as cheap as conventional passive funds, but I suspect the costs are nearer those of active funds, even though there are no fund managers to pay for.
@Gregory, agree the value effect adds a touch of bias towards safety and mitigation of ‘expensive’ stocks. Until the dearth of income, distorted matters, income stocks were a proxy for value and bubble mitigation.
Agree the individual can be patient and take a position, however unpopular, the combination of a global market tracker and an unpopular tilt, over time is likely to give the same long term outcome but may well lack perfect correlation and that can be worthwhile…
Leafing through the Saturday press can at least tell you what sectors not to invest in, just count the ads from fund management groups !
@John B — They are more expensive. To be fair there’s more trading involved, and probably into relatively more illiquid /smaller cap stocks (hence higher spread) though I’ve no idea how much versus the higher fees. Some do seem a backdoor to sneaking higher charges into passive investing.
@The Investor — iShares Edge ETFs are not too expensive. You take a risk 0,10-0,20% cost to achieve 1-2% premium in the long run.
RIT. Your last point is exactly spot on. I have the same issue. My younger sibling, who joined the ‘party’ later than me, does not.
Jack Bogle is skeptical – Dear Jack, 9-10 years is nothing in the history of the markets regarding the factors. And yes, value is riskier in terms of Sharpe ratio. According to EMH vale premium is a compensation for risk.
The Global Stocks Momentum ETF from Vanguard, ‘VMOM’ has been trading now for just over a full year.
A price chart comparison carried out over one year, versus the broad Vanguard Global Stocks ETF, ‘VWRL’ might intrigue?
The book Deep Survival by Gonzalez (quoted in the Netflix v Blockbuster link) is really good BTW. Psychology and neuroscience of people under existential stress.
There are many reasons I don’t believe chasing the factor return is worthwhile but the main one is probably when you work out what the extra return (if it exists) would actually give you. Even the proponents of factor investing seem to suggest only ’tilting’ your investments.
For example a portfolio of 70% equity / 30% bonds with equity tilted 25% towards factors which give say a 1% additional return… 70% x 25% x 1% = 0.175%
It doesn’t seem worth it to me.
It’s not the return that attracts, its the risk adjusted return. For the period 1927-2015 a 60/40 US equity / Treasury portfolio produced an annual return of 8.6% with a standard deviation of 12.2%. However, a 20/20/40 US equity / Small Value / Treasury portfolio achieved 8.9% and 10.4% respectively. Going further, Swedroe’s book gives more information (Ch 9) on risk-parity portfolios that have even better Sharpe ratios than this, constructed from 4 or 5 factor exposures (adding mixes of momentum, profitability, quality).
The science is compelling. The problem is that finding real life investible products to achieve this performance is hampered by fund choice, fees, tracking error, lack of transparency, and so forth.
@TT – The problem with looking at returns for such long periods (ie 1927-2015) is that it hides significant periods of time when there were negative returns. If historic factor returns were to continue (with respect ‘the science is compelling’ can only relate to the past and not the future) then investors would have to accept periods of maybe 10+ years when their returns were below those of cap weighted. Maybe you could stick it out but I am not sure many on this site (including me) could!
@lloyd thats the volatility referred to above. At the risk of sounding like I’m marketing Larry’s book (I’m not), he provides a risk of underperformance chart. Following market beta (total stock market) has a 34/24/18/10/4 risk of losing money over 1/3/5/10/20 year horizons. With illustrative factor portfolios it may be more like 23/10/5/1/0. The actual numbers here are not really important, except to say that there appears to be a diversification benefit by holding factor trackers alongside market beta (whole market). That is, if you can find true, cheap, accurate trackers. I totally appreciate that this can look like fiddling, and if one is happy with a kroijer like portfolio then there is little need to proceed. As mentioned, I’ve not applied such re-allocation, I’m just keeping a watchful eye.
@TT — On the historical evidence for factors etc, the main argument against it is not that the evidence doesn’t exist. As I understand it it is that (a) as you say it’s hard to implement for various reasons (not least that the academic studies often presume you’re also shorting say high P/E stocks, which is not something you ever really hear people talking about) and (b) channeling Lars Kroijer, that it’s presuming edge to think you *know* that these factors will continue. In reality they may just be artifacts of the particular way that capital markets and economies developed over the past 100 years, say. 🙂
@The Investor – I don’t disagree with any of that. Except to say that the factor in a 1 factor model, Market Beta, doesn’t seem outstandingly “special” to other factors of size, value, momentum, quality, when measured against being persistent, pervasive, intuitive, robust. Except perhaps in terms of investability. Market beta is the elephant in the factor zoo, hydrogen in the periodic table, Simon Cowell in x-factor. I’ll not clog up your thread anymore. It’s an interesting topic and glad you gave it some exposure. Loving recent posts.
For the last three years (since my interest in investing really started) I’ve been firmly in the “tracking the global market at lowest cost” camp for the equity part of my portfolio. Above all, I’ve enjoyed the simplicity this brings to life, as it means it takes up very little of my time. However, there are two aspects to this approach that I find challenging, one of which I’ll leave for another day when it’s more relevant to the thread.
I struggle with my portfolio naturally holding more of stock markets as they become more expensive and go above their long term average valuations, and less of stock markets as they become cheaper. It smacks of “buying high, selling low”. And with this resulting in a particularly large concentration in US equities at the moment, I keep challenging the approach.
The reading I’ve done so far around the subject suggests a c.1% p.a. premium in stock returns could be obtained by employing some kind of value approach, based on what’s happened historically (mainly using US data). Where I’ve got to with this, is that, although the logic of value investing makes sense (to me) and has delivered in the past, I enjoy having a simple investment strategy to much. Particularly as I’m still working, and my wife and I have a young baby. I also think that implementing tilts is (as many readers above have mentioned) not straightforward. Certainly paying for someone else to do it could quickly eat into that potential 1% premium.
I’m sticking with the global stock markets approach, but will keep challenging it. I’d be interested to hear other people’s views on the above, and, for those also tracking the global market, if you have any caveats to this approach included in your investment strategy. For example, perhaps you have a rule that you will overbalance back towards bonds/cash if the P/E of US stocks keeps climbing and goes above, say, 30? How about 40?
It is funny for me. Bogle, Ellis argue that nobody knows the future but they say that US returns will be low because historically today’s US market is not cheap. So sometimes history is a good starting point but sometimes isn’t (in the case of factors) for them.
@@ Gregory – I don’t see that Bogle is being inconsistent. His mantra is ‘reversion to the mean’ which is why he suggests that US returns will probably lower and it’s also a key reason why he doesn’t buy into factoring ie he believes that factors work in cycles.
@@ Rob J – I totally agree with you but unfortunately, as I see it, anything other than cap weighted investing is active investing and we know how that usually turns out!
@Lloyd – ‘reversion to the mean’ he knows from history. As we know from history that factors has worked in the very long run. There are long periods when factors underperform. No pain no gain.
“Warren Buffett has been preaching the virtues of value investing for decades. Benjamin Graham’s books on the subject have been around since the 1930s. Everyone now knows that buying cheap or high quality stocks works if you’re patient. Most people aren’t patient. Therein lies your edge as an investor.”http://awealthofcommonsense.com/2015/02/happens-umbrella-shop-gets-crowded/
I agree that factors seem to have worked when you look at academic studies from history (much research exists from DFA and others) but, as The Investor says above, there are no guarantees that they will work going forward. I don’t know if they will and, with respect, neither do you. Bogle’s research into this if I recall correctly looked at actual returns from real funds rather than theoretical returns and he concluded that the evidence of them working in the long run was not there. But maybe you will be proved correct, maybe you just need to be patient over very long periods of time… good luck.
” buying cheap or high quality stocks works”. But you only find out whether they were cheap or high quality with hindsight 🙂 If you think markets are efficiently valued, then any market segment can only outperform if it has a higher risk, ie volatility, than another. I’d not have viewed the US market as that, indeed its current high valuation can be because of its perceived lower risk in uncertain times.
I do have a problem with market efficiency because of human weakness. A stock is not merely valued on the integral of its future dividends, but some intangibles people feel about it, and a key one is how people will feel about the stock when you are ready to sell. So a factor investment segmentation based on exploiting human frailty might work very well. A “They must be mad” ETF anyone?
The main problem with Bogle’s argument is the definition of a factor index.
Bogle refers to Russell 1000 value as value index. The problem is Russell 1000 value is not pure value index. The Russell 1000 Index is a blend Index that contains 999 stocks. Of the 606 stocks held by the Russell 1000 Growth Index, more than 300, or 50%, are also included in the Russell 1000 Value (696 stocks).
The overlap among small cap stocks is similar: 50% of the 1177 components of the Russell 2000 Growth Index can also be found in the value counterpart. This results in surprisingly strong correlation between these Indicies.
Real value indicies/funds like DFA, MSCI Enhanced series (iShares Edge) are more concentrated without meaningful overlapping.
Can You mention any country where value has underperformed in the LONG RUN?
“I’ve learned in my 20 years of experience as an advisor is that most investors, including institutional investors, think three years is a long time; five years is a really long time; and 10 years an eternity. Financial economists know that when it comes to risky assets or factors, 10 years is nothing more than noise. That’s the problem investors have: They fail to understand that, and abandon the factors.”
“Warren Buffett has written for years what his strategy is. But very few people get Buffett-like results, because it isn’t easy. Temperament matters more than intellect.”
http://www.etf.com/sections/index-investor-corner/new-swedroe-book-your-complete-guide-factor-investing?nopaging=1
Factor investing as I see it is a play on stock selection. Something you don’t get when investing in a All-World fund. I believe some pundits have said that it is not stock selection, but asset allocation that is the driver of returns. I will admit this has been something I have found difficult to internalise. I really worry about having a single strategy of being invested in a combination of clearly good and clearly ailing companies through a low cost tracker fund. When I read Fundsmith owner’s manual, it reinforces my belief that not all companies are investible. I have therefore ended up with a hybrid portfolio with some high conviction active funds, and a lifestrategy fund to reduce the overall OCF for my portfolio. Going down to the bone on costs and doing away with any tilts feels insane despite reading Lars, Monevator and the various other sources. Dont get me wrong, I’d really want to be convinced of going passive – I can see the logic – but as of now I dont feel I am wholly persuaded. Sorry, this has ended up being a bit digressive.
@Amit — I believe people approach the fact that asset allocation is the main driver of returns the wrong way (partly because of how it is presented).
It’s not really saying “you have to be really clever and engaged with your asset allocation to get the best returns.”
It is more simply a reflection of the fact that when stocks have gone up for a few decades they’ve trounced the real returns from bonds and shares, to the point of irrelevance almost. (The famous long-term graphs).
But when shares do badly in the short term, they do a lot worse than bonds or cash.
Therefore in an investigation of return attribution, asset allocation is going to loom large. It’s not really saying anything IMHO about whether to be active/passive etc.
This may be very obvious to you, but as I say I have found people getting a bit distracted by it. 🙂
I am frustrated very frequently because I seem to be alone with my passive value mania. Luckily I can read from Swedrore, or Bernstein:
” What investments interest you right now?
Non-U.S. value stocks are cheap. That is, large-cap, foreign-value stocks—banks, utilities, things like that. An indexed investor can easily access them through any of several foreign-value exchange-traded funds. ” http://www.theglobeandmail.com/report-on-business/rob-magazine/invest-like-a-legend-william-bernstein/article33736135/
@Gregory — I wouldn’t be frustrated if I were you. If you’re going to be a contrarian investor, you definitely want to be a lonely contrarian investor. 😉
@The Investor — You are right!
Following on from @TI’s concerns, channelling Lars, that the past 100 years’ data may turn out to be anomalous if only we had access to a longer data series (comment #18 in this thread, end of second point); I just wanted to share some excellent links on very long run factor return (and equity return) data (back to early 1800s for factors and, in one study for equity returns, back to the very beginning of shares in the Dutch Republic in the 1600s):
https://www.twocenturies.com/blog/2019/1/27/a-growing-list-of-long-run-factor-studies
https://www.twocenturies.com/blog/2019/1/27/relevance-of-long-run-historical-data-today
https://www.twocenturies.com/blog/2020/5/11/value-investing-even-deeper-history#