Factor investing

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vnatale
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Factor investing

Post by vnatale » Mon Aug 31, 2020 7:23 pm

I know that there have been discussions in various topics regarding Factor investing. It seems like it's be most appropriate in the context of a Variable Portfolio? But it seems like there have also been discussion regarding it in terms of enhancing the Permanent Portfolio, e.g., Tyler's Golden Butterfly.

Vinny

What’s Driving The Factor Frenzy?

https://www.fa-mag.com/news/what-s-driv ... 50623.html

For many advisors, examining the investment landscape through a factor lens produces a more granular picture of the choices and exposures they can create for clients. Some see it as an advanced, second-generation version of the traditional style-box perspective used by giant fund research concerns like Morningstar. Most academics in finance believe there are five genuine factors—value, quality, momentum, small cap or size and minimum volatility—that create more targeted options than capitalization size and growth versus value.

Twice in recent months, Peter Lazaroff, co-chief investment officer of Plancorp, has found himself at an event where AQR Capital Management founder and CEO Cliff Asness, a thought leader in the field, was delivering the same address. His message: Essentially, nothing is working.

It wasn’t supposed to be that way. Many expected that increased computing power and data availability should be spawning more opportunities for index designers and both rules-based and active managers alike. As Lazaroff sees it, while traditional indexers view security selection as a zero-sum game, factor investing presumes that markets and prices contain vast quantities of information that can be harnessed to construct portfolios that deliver superior returns.

Academic research still indicates he is right. However, the consensus ends when it comes to product design and implementation.


A landscape dominated by disruptive technology giants growing earnings at rates of 20% or more provided the investing theme of the decade. When set against a backdrop of near-zero interest rates, those earnings are perceived as even more valuable.

There is only one problem for investors who want to isolate this kind of unbridled euphoria. Momentum has an uncanny habit of turning on a dime.

Critics argue that momentum is really just a form of performance-chasing that can get you into hot stocks late in the cycle. In early November, Jim Cramer, co-founder of TheStreet.com, raged in public that the liquidation in momentum ETFs was vaporizing the value of his Visa and Mastercard holdings. Other stocks favored by momentum funds, most notably the FANG stocks, also got slammed, but many of the latter group had specific problems of their own (such as regulatory issues).

Few believe that U.S. equities are near 1999 levels, though there are some similarities. Fully 95% of the price of Amazon, probably the leading momentum stock, is “based on future earnings,” Hunstad maintains. “They are going to have to grow to 10% of GDP over the next 10 years to justify that.”

Value

Long before factors were discovered, value investing was rewarding investors with excess returns. Benjamin Graham shared the concept with readers of his books Security Analysis and The Intelligent Investor. Warren Buffett put it into practice for the public to see.


It may be the first and oldest factor, but value is experiencing an extended bout of underperformance. “A lot of people are wondering if value is dead,” Plancorp’s Lazaroff says.

Recent history also shows that when value shines it can be powerful and offer protection. Rarely was this more obvious than in the years 2000 to 2004, when the tech bubble popped and the market punished profitable high-growth companies with almost the same vengeance it did bogus dot-com stocks.

“When value outperforms, it outperforms by a wide margin,” Invesco’s Nguyen says. “It’s hard [for people] to see that today.”

ensive and lose Ben Graham’s prized margin of safety. Just recall the shellacking that energy, materials and financial sectors suffered in 2008.

The Small-Cap Premium


Academic research indicates that small-cap stocks outperform the market over time. Yet once again, that research is being questioned now for a host of different reasons.

Skeptics point to the dramatic shrinkage in the universe of public equities over the past couple of decades: The number of public U.S. companies is about 50% smaller than it was in 1999.

Some believe that many of the best investment opportunities are no longer available in public markets. An investor who bought onetime small-cap Amazon after its 1997 IPO earned a return of about 800 or 900 times the IPO price. Contrast that to a 20-fold increase in Google since it went public in 2004 or the quintupling of Facebook since its 2012 IPO.

The trend of keeping start-ups private longer is only accelerating—there were recently believed to be about 260 so-called unicorn start-ups valued at more than $1 billion, according to CB Insights. At last year’s Inside Alternatives conference hosted by Financial Advisor in Las Vegas, iCapital managing partner Nick Veronis told attendees that today’s VC firms and private investors seem eager to “extract most of the value out of their portfolio companies” before bringing them public.

Much ink has been spilled on how the indexing boom drives up the prices of mega-cap growth companies, but some believe its influence on small-cap equities is even greater. That’s because they are less liquid and fund flows can drive even more extreme price swings in this sector.

Can multifactor investing be timed in the same fashion that some professional investors deploy sector rotation? Balasa says most of the serious research on this subject isn’t encouraging. It strongly suggests the best alternative is to select a factor weighting appropriate for the client and leave it in place.

State Street’s Bartolini goes further. “If you are timing factors, you are playing with fire,” he warns. If the goal is timing, he goes so far as to advise that it be executed at the single stock level, not with ETFs.

Logical though it sounds, broad multifactor diversification begs another question. Why not just buy the total market index?

The answer will likely emerge after the next major bear market when advisors will find out if factor investing really lives up to its billing and delivers excess returns with a lower beta.
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Re: Factor investing

Post by boglerdude » Tue Sep 01, 2020 12:43 am

Factors are too well known now and managers can front run a niche index. Even (especially!) an index they manage. Nickles on millions of small transactions is how wall st gets rich
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Re: Factor investing

Post by vnatale » Tue Sep 01, 2020 7:30 am

boglerdude wrote:
Tue Sep 01, 2020 12:43 am
Factors are too well known now and managers can front run a niche index. Even (especially!) an index they manage. Nickles on millions of small transactions is how wall st gets rich
Yes. Michael Lewis's book on High Frequency Trading. Where millions are spent to gain a split second advantage.

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Re: Factor investing

Post by Kbg » Tue Sep 01, 2020 9:17 am

Momentum works extremely well but it does take quite a bit of research to figure out the details of a tradeable approach and you have to be willing to take some brutal draw downs from time to time or figure out a way to mitigate the draw downs.

I have no real idea of why some of these things have stopped working, but my best guess is:

1) Commoditization (is this a word?) of these factors. This is a well known phenomenon...discover, publish, popularity, no longer works.

2) In the commercial investing world the key is "it scales well" meaning you can package it up and sell it to a whole bunch of people with the goal of making money via fees for an ever larger AUM. Often times this means either not actually applying the academic technique from the literature or using so many assets (stocks) that the fund ends up not being hugely different from a good index fund. Add on top of that usually much higher fees and that's recipe not super great for shareholders. Finally, most factor research takes the top X % and goes long in those stocks and takes the bottom equivalent X% and shorts those stocks. If you peel the banana on most of these funds, no one is shorting.

3) Diverging too far from a benchmark will get you fired (see #2 above).

4) Right or wrong, pretty much anything not tech hasn't been super successful for quite a while now.
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Re: Factor investing

Post by Kevin K. » Tue Sep 01, 2020 10:42 am

My guess is that those in a position to make some money fairly often with factor investing are hedge funds with substantial research staffs and the ability to execute trades 24/7 worldwide. Bridgewater comes to mind and of course they've placed plenty of bets that turned out to be incorrect.

On the other hand I've also come to think that rigid "stay the course" fundamentalism, be it of the Bogleheads or PP variety, that doesn't take into account macroeconomic and political conditions, is also short-sighted. So for example I think there are good arguments to be made for not holding anything but short-duration bonds in a zero-return environment, for making sure to include international and EM equities given the FAANG-driven frenzy in TSM/QQQ, and for making sure to have a decent allocation to gold given all of the currency debasement and government debt increases.
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Re: Factor investing

Post by Tyler » Tue Sep 01, 2020 11:18 am

I'm a fan of stock factors in portfolio building, but I absolutely agree that they're commonly abused and misunderstood by laypeople and professionals alike. Personally I think two areas that lead many overzealous factor investors astray are:

1) Unrealistic academic definitions that pump up numbers in a way that can't be replicated in the real world. When your own returns don't match expectations, it could just mean that the academic who set your expectations didn't know how real-world funds operate.

2) A fixation on superior excess returns for single assets over diversification of the portfolio as a whole. Basically, they care about the carrots more than the cake. IMO, factor funds are way more interesting as part of a larger recipe than as individual invetsments in isolation.
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Re: Factor investing

Post by vnatale » Mon Sep 07, 2020 9:09 pm

Another view...

Vinny

Finke: How Swedroe and AQR Are Hunting Alpha (and You Can, Too)

There’s a new breed of multifactor ETFs that use a mix of research-based strategies.

https://www.thinkadvisor.com/2019/09/24 ... for-alpha/
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Re: Factor investing

Post by Smith1776 » Tue Sep 08, 2020 3:37 pm

Factor diversification is still the way to go as far as I'm concerned. The efficient frontier of risk in a CAPM world was a unidimensional analysis that essentially had a single variable relationship between risk and reward. It's easy to visualize on a 2D graph.

Adding one more factor turns that line into a 3D surface. Adding additional factors beyond that becomes impossible to visualize, which is why I think it's such a challenge explaining factor investing to the layman. You have to go from a visual chart to a table when looking at more factors, and that's less intuitive.

A note on adding factors to your portfolio. You should seek to add factors by using multi-factor funds instead of multiple single factor funds. This typically creates a more efficient implementation. Multi-factor funds can screen stocks for momentum, size, quality, etc. simultaneously, and buy the stocks that have the highest composite score. Additional finessing is required to ensure that excessive sector concentration and/or idiosyncratic risk doesn't show up.

By contrast, using multiple single factor funds (one for value, one for momentum, etc.) is usually less efficient. As an example, value stocks typically enter the value regime because they've fallen in price. This likely means they have negative momentum. So you might have your momentum fund selling a stock while at the same time your value fund is buying it. This creates two transactions, two expenses, and no net change in position!

You can see this problem crop up in the Vanguard single factor fund implementations for momentum and value.


Vanguard Momentum ETF:
Vanguard Momentum ETF.png
Vanguard Momentum ETF.png (51.26 KiB) Viewed 198 times

Vanguard Value ETF:
Vanguard Value ETF.png
Vanguard Value ETF.png (43.59 KiB) Viewed 198 times


Notice how the Momentum ETF loads negatively on value while the value ETF loads negatively on the momentum factor. This creates a self neutralizing effect that reduces overall portfolio factor exposure and therefore diversification. It's like pressing on your car's brake and gas pedal at the same time.

Companies like DFA that take a multi-factor approach can gain you exposure to multiple factors simultaneously and create a more efficient portfolio.


DFA Value ETF:
DFA Value ETF.png
DFA Value ETF.png (38.45 KiB) Viewed 198 times


Notice how the DFA fund loads positively on all factors, albeit some more than others. It is still nonetheless a much more efficient fund, despite the higher expense ratio. That also brings up something else to consider: you shouldn't look at expense ratios alone when choosing a fund. You should look at the expense per unit of exposure. A more expensive fund with deeper factor exposure can be well worth the money. O0
Price is what you pay; value is what you get.
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