Dumb Talk About Smart Beta?

October 7, 2013

John Rekenthaler at Morningstar, who usually has some pretty smart stuff to say, took on the topic of smart beta in a recent article.  Specifically, he examined a variety of smart beta factors with an eye to determining which ones were real and might persist.  He also thought some factors might be fool’s gold.

Here’s what he had to say about value:

The value premium has long been known and continues to persist.

And here’s what he had to say about relative strength (momentum):

I have trouble seeing how momentum can succeed now that its existence is well documented.

The italics are mine.  I didn’t take logic in college, but it seems disingenuous to argue that one factor will continue to work after it is well-known, while becoming well-known will cause the other factor to fail!  (If you are biased in favor of value, just say so, but don’t use the same argument to reach two opposite conclusions.)

There are a variety of explanations about why momentum works, but just because academics can’t agree on which one is correct doesn’t mean it won’t continue to work.  It is certainly possible that any anomaly could be arbitraged away, but Robert Levy’s relative strength work has been known since the 1960s and our 2005 paper in Technical Analysis of Stocks & Commodities showed it continued to work just fine just the way he published it.  Academics under the spell of efficient markets trashed his work at the time too, but 40 years of subsequent returns shows the professors got it wrong.

However, I do have a background in psychology and I can hazard a guess as to why both the value and momentum factors will continue to persistthey are both uncomfortable to implement.  It is very uncomfortable to buy deep value.  There is a terrific fear that you are buying a value trap and that the impairment that created the value will continue or get worse.  It also goes against human nature to buy momentum stocks after they have already outperformed significantly.  There is a great fear that the stock will top and collapse right after you add it to your portfolio.  Investors and clients are quite resistant to buying stocks after they have already doubled, for example, because there is a possibility of looking really dumb.

Here’s the reason I think both factors are psychological in origin: it is absurdly easy to screen for either value or momentum.  Any idiot can implement either strategy with any free screener on the web.  Pick your value metric or your momentum lookback period and away you go.  In fact, this is pretty much exactly what James O’Shaughnessy did in What Works on Wall Street.  Both factors worked well—and continue to work despite plenty of publicity.  So the barrier is not that there is some secret formula, it’s just that investors are unwilling to implement either strategy in a systematic way–because of the psychological discomfort.

If I were to make an argument—the behavioral finance version—about which smart beta factor could potentially be arbitraged away over time, I would have to guess low volatility.  If you ask clients whether they would prefer to buy stocks that a) had already dropped 50%, b) had already gone up 50%, or c) had low volatility, I think most of them would go with “c!”  (Although I think it’s also possible that aversion to leverage will keep this factor going.)

Value and momentum also happen to work very well together.  Value is a mean reversion factor, while momentum is a trend continuation factor.  As AQR has shown, the excess returns of these two factors (unsurprisingly, once you understand how they are philosophical opposites) are uncorrelated.  Combining them may have the potential to smooth out an equity return stream a little bit.  Regardless, two good return factors are better than one!

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Stock Market Valuation

May 7, 2013

Stock market valuation is always a concern for investors.  Presumably it always helps to buy when valuation is low.  However, I’m no expert on stock market valuation.  In the past, I’ve shown some bottom-up valuations constructed by Morningstar analysts.  They suggest the market is fairly valued right now.  Another way to look at it is top-down; that is, taking the big picture view of valuations.

That’s what Ed Yardeni of Dr. Ed’s Blog does.  From a big picture perspective, there are just two main variables in stock market valuation: earnings, and the multiple you put on those earnings.  Lots of firms estimate aggregate S&P 500 earnings.  (Top-down estimates actually tend to be a little more accurate than bottom-up estimates.)  In this version, he uses the Thomson Reuters IBES estimate.  For his estimate of the appropriate multiple, he uses 20 minus the 10-year yield.  That kind of thinking makes sense.  With low interest rates, the market has typically traded at a higher multiple.  When interest rates or inflation are high, the PE multiple tends to get compressed.  He points out that other versions of this chart, like using a multiple of 20 minus CPI inflation come out in the same ballpark.

Here’s the chart from his recent article on valuation:

Source: Dr. Ed’s Blog    (click on image to enlarge)

It’s an interesting chart, is it not?  Based on earnings, it suggested the market was significantly overvalued in the late 1990s, and then fairly valued from 2002 to 2007 or so.  The market dropped appropriately in response to weak earnings during the financial crisis, but is now about 30% undervalued, not having kept up with the rapid earnings growth we’ve seen since then.  The suggestion is that if earnings hold up, current stock prices are not out of line with the past decade.

It’s well worth reading the rest of the article, as Dr. Yardeni also discusses the relative valuation of stocks versus bonds.  (The whole blog is worth reading!  He is one of the more practically grounded economists out there.)

My takeaway on this is simply that the current market may not warrant the incredible amount of hand-wringing that we’ve seen as the S&P 500 has pushed to new highs.  Given the powerful corporate earnings we’ve seen, coupled with very low interest rates, the market’s valuation may be reasonable.  Yes, it feels scary because we are in new high ground, but the data looks different than we might feel emotionally.

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Quote of the Week

March 4, 2013

The class of those who have the ability to think their own thoughts is separated by an unbridgeable gulf from the class of those who cannot—-Ludwig von Mises

Orthodox thinking will keep you out of trouble.  In the investment industry, if you build a client’s portfolio in rigid conformance with Modern Portfolio Theory, your firm will back you and it is unlikely that you will ever be successfully sued, regardless of how horribly things turn out for the client.  And make no mistake—building portfolios based on mean variance optimization doesn’t have a very good track record.

Unorthodox thinking, as uncomfortable as it may be for some, is also the only way the human race advances.  After all, nearly every current orthodoxy was once out of the mainstream.  It’s good to have new ideas bubbling up, prepared to take the place of our current king of the hill if they can demonstrate their worth in practice.  (Theory that doesn’t work in practice isn’t much of a theory.)

I’m encouraged to see factor-based investing and broad diversification advancing at the expense of Modern Portfolio Theory.  Relative strength tests well as a return factor, as do value and low volatility.


HT to Michael Covel

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Relative Strength vs. Value – Performance Over Time

May 31, 2012

Thanks to the large amount of stock data available nowadays, we are able to compare the success of different strategies over very long time periods. The table below shows the performance of two investment strategies, relative strength (RS) and value, in relation to the performance of the market as a whole (CRSP) as well as to one another. It is organized in rolling return periods, showing the annualized average return for periods ranging from 1-10 years, using data all the way back to 1927.

The relative strength and value data came from the Ken French data library. The relative strength index is constructed monthly; it includes the top one-third of the universe in terms of relative strength.  (Ken French uses the standard academic definition of price momentum, which is 12-month trailing return minus the front-month return.)  The value index is constructed annually at the end of June.  This time, the top one-third of stocks are chosen based on book value divided by market cap.  In both cases, the universes were composed of stocks with market capitalizations above the market median.

Lastly, the CRSP database includes the total universe of stocks in the database as well as the risk-free rate, which is essentially the 3-month Treasury bill yield. The CRSP data serves as a benchmark representing the generic market return. It is also worthwhile to know that the S&P 500 and DJIA typically do worse than the CRSP total-market data, which makes CRSP a harder benchmark to beat.


Source:Dorsey Wright Money Management

The data supports our belief that relative strength is an extremely effective strategy. In rolling 10-year periods since 1927, relative strength outperforms the CRSP universe 100% of the time.  Even in 1-year periods it outperforms 78.6% of the time. As can be seen here, relative strength typically does better in longer periods. While it is obviously possible do poorly in an individual year, by continuing to implement a winning strategy time and time again, the more frequent and/or larger successful years outweigh the bad ones.

Even more importantly, relative strength typically outperforms value investment. Relative strength defeats value in over 57% of periods of all sizes, doing the best in 10-year periods with 69.3% of trials outperforming. While relative strength and value investment strategies have historically both generally beat the market, relative strength has been more consistent in doing so.

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Combining Relative Strength and Low Volatility

October 12, 2011

The power of relative strength as a return factor has been well documented and that evidence is the reason that relative strength drives all of our investment strategies.  However, just because it is a winning return factor over time doesn’t mean that anyone should or will construct an asset allocation composed entirely of relative strength-based strategies.  Financial advisors who are in a position to decide which strategies to include in an asset allocation must then decide how to find complementary return factors.  We have previously written about the benefits of combining relative strength and value, for example.

However, it appears that value is not the only suitable complement for relative strength strategies.  Another option would be to consider combining the recently introducted PowerShares S&P Low Volatility Portfolio (SPLV) with our own PowerShares DWA Techical Leaders Portfolio (PDP).

A description of each is as follows:

The PowerShares DWA Technical Leaders Portfolio (PDP) is based on the Dorsey Wright Technical Leaders™ Index (Index). The Fund will normally invest at least 90% of its total assets in securities that comprise the Index and ADRs based on the securities in the Index. The Index includes approximately 100 U.S.-listed companies that demonstrate powerful relative strength characteristics. The Index is constructed pursuant to Dorsey Wright proprietary methodology, which takes into account, among other factors, the performance of each of the 3,000 largest U.S.-listed companies as compared to a benchmark index, and the relative performance of industry sectors and sub-sectors. The Index is reconstituted and rebalanced quarterly using the same methodology described above.

The PowerShares S&P 500® Low Volatility Portfolio (SPLV) is based on the S&P 500® Low Volatility Index (Index). The Fund will invest at least 90% of its total assets in common stocks that comprise the Index. The Index is compiled, maintained and calculated by Standard & Poor’s and consists of the 100 stocks from the S&P 500 Index with the lowest realized volatility over the past 12 months. Volatility is a statistical measurement of the magnitude of up and down asset price fluctuations over time.

The efficient frontier below points out that combining the two can be an effective way to reduce the volatility and/or increase the return over using PDP or SPLV independently. 

(Click to enlarge)

The table below is also for the period April 1997-September 2011.  (The hypothetical returns for PDP only go back to April 1997.)

Perhaps most interesting to asset allocators is the fact that the correlation of excess returns of PDP and SPLV over this time period was -0.29.  The goal of asset allocation is to not only add value, but to also construct an allocation that clients will stay with for the long-run.  Rather than whip in and out of PDP, perhaps a more enlightened approach is to buy and hold positions in both PDP and SPLV for a portion of the allocation.

For the time periods when hypothetical returns were used, the returns are that of the PowerShares Dorsey Wright Technical Leaders Index and of the S&P 500 Low Volatility Index.  The hypothetical returns have been developed and tested by the Manager (Dorsey Wright in the case of PDP and Standard & Poors in the case of SPLV), but have not been verified by any third party and are unaudited. The performance information is based on data supplied by the Dorsey Wright or from statistical services, reports, or other sources which Dorsey Wright believes are reliable.  The performance of the Indexes, prior to the inception of actual management, was achieved by means of retroactive application of a model designed with hindsight.  For the hypothetical portfolios, returns do not represent actual trading or reflect the impact that material economic and market factors might have had on the Manager’s decision-making under actual circumstances.  Actual performance of PDP began March 1, 2007 and actual performance of  SPLV began May 5, 2011.  See PowerShares.com for more information.

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