by Charles Roth, Thornburg Investment Management
Turns out price matters for excess returns, and that what’s worked before doesn’t necessarily persist into the future. “Many factors aren’t real.”
Whatever the marketing nomenclature, there are no silver bullets in investing. Trades get crowded. Markets evolve. And back-tested quantitative strategies that may have worked historically haven’t necessarily been working lately. Or even, it appears, for some time.
Passive factor investing, which purports to replicate methods long employed by active managers, hasn’t delivered the goods for well over a decade, according to new academic research led by Rob Arnott, the “godfather of smart beta.” The article, which is scheduled to run in the Journal of Portfolio Management in April, notes that “the diminishing performance of a factor after its publication is remarkable.”1
That’s not all. “An even more striking fact, that we think has garnered far too little attention, is that factor performance in the most recent 15 years has largely vanished for the most popular factors…not a single one has delivered a statistically significant excess return since 2003,” the researchers point out.
The space between promise and proof of quant investing’s results is starting to come under wider scrutiny, though. At the same time, the outperformance of the “average”—not top decile or quartile—active equity fund manager in several geographies is starting to get noticed. Perhaps the use of human judgment in harnessing quantitative, backward-looking analytics and joining it with forward-looking qualitative analysis, is valuable. And not just in picking select stocks and bonds on their individual merits, but also in considering how they each contribute to a portfolio that can become more than the sum of its parts, offering less correlated risk than a market portfolio.
After all, as Thornburg president Jason Brady points out in a just-published Q&A, “It’s not just diversification for the sake of it…I want an active portfolio that’s providing me good risk-adjusted returns in and of itself and has a lower correlation either to other portfolios or to a broad-based benchmark. That should improve my overall portfolio return.” How? “It’s knowing the risks you take, because investing is about risk…but taking those risks in a purposeful way, as opposed to just getting what the broad market offers.”
As Factors Proliferate, “Diversification Can Vanish”
In December, Bloomberg Opinion columnist Nir Kaissar featured Ohio State University finance professor Lu Zhang, who co-authored a study in 2017 that analyzed 452 factors, the vast majority of which didn’t perform as advertised.2 Only 18% held up, but were effectively variations of the value factor (shares trading at a perceived discount to business fundamentals), the quality factor (stocks with good return on equity, stable earnings and low leverage) and the momentum factor (share prices exhibiting upward thrust). Moreover, Zhang notes “the factors are correlated, so they’re not entirely independent.” Arnott, in his research, found much the same: “Diversification can vanish…in certain economic conditions, when factor returns become much more correlated.”
Why do factor investing’s diversification and alpha generation appear to wilt over time? “Many factors aren’t real,” Arnott told ThinkAdvisor in late February.3 Those that are “worked historically, but that doesn’t mean they’ll work in the future.” Why not? As Brady suggests, you can only extrapolate so much from historical performance given the limitations of the market data set. “It lacks historical depth in many asset classes,” Brady notes. Most asset classes have only been around a few decades, during which “we really haven’t seen market conditions that are tremendously different,” he adds. “So the data set is quite correlated.”
To be sure, dividend-paying stocks exhibit a good mix of the value, quality and cash flow factors, and have demonstrated some staying power. But most conventional factor assumptions haven’t lasted long. U.S. value-tagged stocks were considered a better bet than growth stocks until 2008, but that flipped after the Global Financial Crisis. Small capitalization stocks had long been assumed to outperform large-caps, but that too hasn’t been the case since 2011. As for momentum strategies, which are largely a growth variant, elevated trading costs tend to undercut returns, Ohio State’s Zhang points out.
Those shifts are borne out in the standard disclaimer in investment management: past performance does not guarantee future returns. But astute active portfolio managers can boost the odds of future returns, whether stocks are classified as value or growth, across the capitalization spectrum, by accurately assessing a company’s business fundamentals and determining whether its share price properly reflects them. Shares prices often dislocate from business fundamentals amid the ebb and flow of broad market indices. And, as we pointed out in our Efficiency Factor whitepaper last fall, it’s easier to interpret a single firm’s near-term cash flows and valuation metrics than to assess an index’s aggregated valuations and predict when the index should mean revert to reflect its purported fair value.
Value and Low-Vol’s Limited Protection, and the Perils of Popular Factors
Nor does the factor-based index necessarily serve its purpose. For example, from the start of the global market volatility in late January 2018 through March 12 of this year, the value segments of the MSCI USA and MSCI ex-USA indices haven’t protected on the downside, as hoped, compared to their broader benchmarks (chart 1). And in the 15 years to the end of 2018, the annualized total return of the MSCI USA Index amounted to 7.83%, outperforming the MSCI US Value Index’s 7.02%. Likewise, the MSCI ACWI ex-US Index outperformed its value carve-out in the same period, although the annual margin differences were tighter: 81 basis points and 16 basis points, respectively. Certainly some number of the value stocks included in the value-based indices are cheap for good reason, suffering from poor fundamentals. Value traps drag on index returns.
As we detailed a few years ago, low-vol ETFs did deliver lower beta (a measure of market risk) than relevant indices, though they mostly failed to produce much by way of differentiated total returns in measurement periods up to five years at that time. During shorter volatile periods, they have tended to hold up, but then lagged once the broad market found its footing and advanced. But trying to time the shifts can be a perilous exercise. Perhaps Goodhart's Law, which posits that when a measure becomes a target it ceases to be a good measure, has something to do with it. When investors pile into a popular factor, they often end up effectively investing in the passive vehicle’s underlying stocks at a premium, undercutting the odds that the expected alpha will be achieved.
Conversely, that can also make it easier for active managers to outperform passive by skirting richly priced securities and identifying those with more upside potential. Japan may have turned into a case study for investing with a “margin of safety,” as value investing’s godfather, Ben Graham, would say. The Bank of Japan has been buying straight index-linked ETFs as part of its quantitative easing exertions to juice the country’s economy and inflation, and now reportedly controls more than three-quarters of the local equity ETF market. According to S&P Dow Jones’ SPIVA scorecard, significant majorities of Japanese actively managed large-cap and mid/small-cap equity mutual funds outperformed their benchmark indices in the one-, three- and five-year periods at end June, 2018, the latest data available.
Yet active equity outperformance doesn’t appear limited to Japanese equities. Writing in the Wall Street Journal, Derek Horstmeyer, a finance professor at George Mason University, found the average active manager in country-focused equity mutual funds in India, Mexico, China, the U.K., Canada, Japan and Australia outperformed net of fees in five- or 10-year periods, or both, by marginal amounts in some cases and material margins in others.4
In reference to the rather startling influence of the BOJ in Japan’s equity market, and active manager outperformance there, Brady remarked in the Q&A:
If you cross streets without looking, that may be cheaper as far as your time’s concerned. But sometimes you get run over. If many people are doing it, then maybe more people are in danger of getting run over. So the value of looking goes up. It is interesting that we’re at a place where using judgment is regarded as foolish and not using judgment is regarded as intelligent. Is there a flow argument to the rise of passive markets or passive vehicles? In the sense that the more flows that go into something, the more valuable it becomes; there’s probably a bit of that. Is there a point at which that flow reaches a tipping point and the price exceeds the value? Also possible.
As for the smart beta variety, Arnott was rather blunt with ThinkAdvisor about the nature of their inflows. “Smart beta used to mean something—strategies to break the link between a stock’s price and its weight in the portfolio so that you’re rebalancing alpha. But it doesn’t mean that anymore,” he said. “The industry has commandeered the expression. It became a very powerful marketing tool…Pretty soon ‘smart beta’ was attached to everything under the sun.”
1. Alice’s Adventures in Factorland: Three Blunders that Plague Factor Investing, Arnott, Harvey, Kalesnik, Linnainmaa, February, 2019.
2. Professor Has Some Questions About Your Index Funds, Nir Kaissar, Bloomberg News, Dec. 24, 2018.
3. Rob Arnott: Factor Investing is “Overhyped,” ThinkAdvisor, Feb. 26, 2019.
4. “Where Active Management Still Dominates,” Wall Street Journal, Derek Horstmeyer, March 3, 2019.
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