“More investors don’t copy our model because our model is too simple. Most people believe you can’t be an expert if it’s too simple.” ~Charlie Munger when asked why more investors hadn’t copied Berkshire Hathaway’s approach to investing*
Value and other forms of factor investing aren’t new. They’ve been around for a while now and are widely documented in the academic research. So, if systematic investing based on these factors isn’t a novel concept to any attentive observer, how can the strategies still work?
For anyone considering factor strategies this is a good question to ask and one Cliff Asness, the founder and CIO at investment firm AQR, addressed in the September 2015 issue of Institutional Investor with an article titled “How Can a Strategy Still Work If Everyone Knows About It?”
First, Why Do Factors Work at All?
The key to understanding why we expect these factors to work in the future is to understand why they have worked in the past. Ken French, who along with Nobel Laureate Gene Fama pioneered most of the early research on factor investing, has a joke (it’s a joke because it’s overly precise) that the factors exist due to “89.1% risk and 10.9% mispricing.”
Joking aside, most accept that it’s some combination of these affects which drive factor premiums.
A Risk Premium
Usually, the explanation starts with risk. Most academics and practitioners agree with French that the majority of the premium is compensation for additional risk. Think about a value strategy, where often the value stocks it owns are cheap for a reason—some form of recent poor performance, financial distress, etc. As Fama has said (I’m paraphrasing), “these are stocks you hold your nose and buy.”
And Asness, in the article mentioned previously, puts it as follows:
“The first reason is they work because the investor is receiving a rational risk premium. … If the long (cheap) stocks are, in some relevant sense, riskier than the short (expensive) stocks — and riskier not just individually, which can be diversified away, but as a portfolio — then it’s completely rational for them to be awarded a higher expected (or average) return. Now, keep in mind, to be risky, that investment has to lose sometimes.”
The bottom line is that for those who can afford to bear the risk, and wait for the higher expected average return to show up, this premium is completely rational; and it comes at the expense of those who cannot bear the risk or cannot afford to be patient.
Next, these strategies also can work due to errors that investors in aggregate make or due to certain preferences of the collective whole. For example, many prefer to own the hot stock with the exciting growth story (think Tesla or Nintendo post- Pokémon GO) over a boring “value” stock. Morgan Housel, writing for the Motley Fool, puts it like this:
The best-performing industry over the last 50 years, by far, is consumer staples things like food, toothpaste, and toilet paper. The worst-performing industry, by far, is technology.
Simplicity and boredom wins almost everywhere you look in investing, especially over long periods of time. Equally true: A lot of people don’t want to believe it. Many investors are too busy trying to get rich to have any time to focus on what works.
Factors can work because they’re compensation for risk and due to investor errors. And according to Asness this may happen at different times, but they can still both be true:
“Of course, just to complicate things, these explanations are not mutually exclusive. They can both be true. Furthermore, their relative impact can vary through time. For example, cheap value stocks might usually be cheap because they are riskier, but in the 1999–2000 technology bubble they were too cheap because investors were making errors.”
How Would We Know if Factors Stopped Working?
If factors are revealed in the data and we have a good explanation for why we would expect a premium for them going forward, this gives us confidence that they will continue to work.
But, what would it look like if they stopped working? How would we know it?
Again, Asness addresses this question. He makes the point that if these strategies were so popular now that you wouldn’t expect a premium going forward, it would show up in two ways:
- The historically observed spread between the cheap stocks and the expensive stocks would narrow (sticking with the value factor as the example).
- If a factor were too popular it would show up in the observed volatility of the strategy due to money flowing in and out of the strategy.
According to Asness, the data reveals neither.
Below is a graph of the Value Spread** for stocks going back to the mid-fifties. What you should notice is that we are right about the historical average.
Asness put it like this:
The current level is almost exactly at the 60-year median. While the strategy might be more exciting to invest in at times like the peak in 1999–2000 or the milder but still famous growth stock frenzy of the late 1960s and early 1970s, one usually has to suffer greatly before those opportunities turn profitable! Anyway, fairly basic measures like these show little evidence of a strategy that’s recently been arbitraged away.
And, as it relates to volatility the conclusion is the same—there is little evidence that popularity is driving an increase in volatility.
A Few Final Points
Lastly, Asness sums up his article with a few final points.
- While money has been moving into systematic, factor investing, it has to come from somewhere. To the extent that it’s coming from traditional higher-cost, stock-picking funds with a value bias already this is not really new money devoted to value investing. Just a different (i.e., superior) form of value investing.
- Next, he doesn’t buy the story that these factors are actually “known” or at least fully believed. He states, “We encounter skeptics every day who find that these strategies are too simple, leave out too much (how can anything work without the judgment of a skilled stock picker?) or are just too naïve to be effective.”
- And lastly to those saying these strategies will get arbitraged away he writes, “In truth, it’s unlikely that even real arbitrage opportunities — let alone attractive expected returns (an expected return is not an arbitrage as it sometimes loses!) — get fully closed” due to several academically discussed limits to arbitrage.
Factor investing has worked in the past and for the reasons outlined above, we think it will continue to provide a premium going forward. However, this premium will only be realized by those investors deliberate and patient enough to stick with their strategy over time.
As Charlie Munger suggested, just because something is straightforward and understood doesn’t mean it stops working.
Part Four in the Factor series is here.
*For those unaware, Charlie Munger is the vice chairman of Berkshire Hathaway and Warren Buffett’s right-hand man.
**As measured by the book-to-price ratio of the cheapest third of US stocks compared to the most expensive third of US stocks.
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