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Factor Investing – Tilting at Windmills

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Great quote from Sagan! I take it to heart. 🙂

From what I’ve seen of factor investing funds so far, the returns promise a marginal improvement over buy and hold. But on the other hand, at least in the ETF wrapper, the fees haven’t been too bad… around .50%-.75%, not counting Goldman’s earth shattering .35% or so. Is this all on the level of “high fees”? ‘cuz its all pretty darn low compared to business as usual in mutual funds. We’re playing in like a 1% sandbox here… Schwab at the bottom, whoever it is at the high end. Any factor or factor composite would have to produce at least a fraction under 1% to be at break-even. It doesn’t seem like a very high bar to me?

OTOH, you always like to say that the evidence is “pretty compelling” that this or that doesn’t work, but you’re just basing that on a simple (super) majority of funds not outperforming their benchmark indexes in SPV reports. You ignore the minority that clearly do beat their benchmark indexes, which in this case, would have been from 22% to 1%. That’s clearly a significant gap that would make me hesitant to ever say “pretty compelling”. So I assume you keep saying that because you’re advocating for the lowest cost, most passive approach to investing targeted at the “dumb money” and not “smart money”. Correct?

My hypothesis about why funds (including factor-based) may suck is it all comes down to the liquidity issue. After all, only the best performing 25% of all stocks since 1983 accounted for all of the stock market’s gains (there’s a more recent paper with even worse stats going back farther but I can’t find it again). But because this is a fund being used as an investment vehicle, you have to do something about the cash continuously flowing in from me-to FOMO investors, hence you’re forced to mission creep or the fund was designed not to be narrowband from the outset which certainly looks like the case in the traditional three factors at the moment. The Vanguard “small cap value” is gawd awful bad.

Do we have the same limitations as individual investors? No way, Jose! If you can develop a method to cull that 25% winners from the other 75% garbage that you are not forced to buy, you will earn above average returns. This is why Buffett says he’d make 50% a year if he didn’t have the size problem… the same logic holds true for funds. I will go on the record here and declare that any fund that does NOT ever close to new money to stay true to its narrowband mission is a scam. How do you tell a Ponzi from a legitimate investment opportunity? The former never closes.

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Posted by MachineGhost
Posted on 04/26/2017 5:11 PM
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Why cant the firm repeat the same narrow choice as the new cash comes in.

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Posted by Dinero
Answered on 04/27/2017 11:18 AM
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    Well, because that bloats the securities up from under/fair valued to overvalued as the money goes into the same exact securities over and over again. So there’s no way to stay true to the narrow bandwidth mission if you don’t stop accepting new cash inflows. Due to the incentive structure, that’s not in any fund manager and their employee’s best interests. They are paid on growing assets not performance, although hedge funds is a Frankensteinian mix of the two. Offhand, I know only of a few mutual funds that have ever closed to new investors and they’re typically not the name-brand ones and they’re focusing on the micro or small cap space. Hedge funds definitely close regularly. I don’t know if they ever re-open but closed mutual funds sometimes do.

    Here’s another example to think about. With Central Banks acting insane and monetizing stocks via purchasing low-cost “passive” indexes which are all market-cap weighted, the stocks that are outpacing the S&P 500 gains are the ten largest: Alibaba, Alphabet, Amazon, Apple, Berkshire Hathaway, Exxon, Facebook, Johnson & Johnson, JP Morgan and Microsoft. The Swiss central bank now owns more shares of Facebook than Mark Zuckerberg himself; overall $500b in stocks worldwide. Japan’s central banks now owns more than 10% of every company in the Nikkei and is the largest shareholder in over 55 companies.

    As much of a fan that Roche seems to be of public-private partnerships, does anyone really think in their deepest hearts of hearts that the politicians and academics running government understand literally anything about real world economics, investing, trading, etc??? Don’t answer that!

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    Posted by MachineGhost
    Answered on 04/27/2017 2:38 PM
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      I’m not totally against factor investing. But the problems are many at present:

      1) Most factor funds are relatively high fee and closer to 1% than 0.35%.

      2) Most factor funds give you little uncorrelation relative to a simple market cap weighting.

      I am not at all against active management. I mean, I am pretty clear that we’re all active managers. But you want to be active in a smart way. That means reducing your tax bill and fee bill while implementing an appropriate strategy. Keep in mind that “appropriate” does not mean market beating. Beating the market is not a financial goal for anyone. So the thing I am wary of is people who sell the hope of alpha in exchange for the guarantee of high fees. That person is a huckster in 9 out of 10 cases.

      As a simple example, if you gave me the option of Risk Parity at 0.5% per year or 60/40 at 0.25% per year I’d take Risk Parity every single time. A strategy like Risk Parity is just smart risk management whereas 60/40 has virtually no risk management because the 60% stock piece dominates the risk in the portfolio by so much.

      So yeah, active management is fine. But it’s gotta be done right.

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      Cullen Roche Posted by Cullen Roche
      Answered on 04/27/2017 2:45 PM
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        The bigger challenge I see is I will read something like your work which suggest there is little to gain from factor investing if you own a closet indexers with high fees. And then I will read a strategy like the dividend aristocrats that presents nice long term graph outperformance and thing well this seems like a no-brainer even if the fee is say 1%.

        Is there anyway to get a clear picture of what is “real” factor and what is “noise” when it comes to factor as you can find the case for/against for anything. Do you have any opinion on the aristocrat strategy (it seems like a quality/defence factor)?

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        Answered on 04/30/2017 11:58 AM
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          Is there a fund you’re referring to specifically?

          The main problem with dividends is:

          1) Your after tax return is likely to be lower because you’re incurring the tax liability on the dividends every year.

          2) Most of these funds don’t even beat the S&P 500 before taxes and fees. Even Vanguards longest standing dividend mutual funds have performance that is basically in-line with the S&P 500.

          This all makes sense. Firms that pay dividends don’t generate higher profits. There isn’t some magical law that says firms paying dividends are operating better. All a dividend is is a payout of retained earnings. In fact, relative to the index, these firms MUST generate lower after tax returns for their shareholders because the dividends get taxed. In a perfect world the S&P 500 would pay no dividends and the firms would reinvest all their retained earnings in their businesses. That’s not the case obviously. And people like the income. So there’s good reason for dividends, but they’re not a free lunch.

          Meb has done the best work on this dividend investing myth. Read more here:

          http://mebfaber.com/2017/04/26/dividend-growth-myth/

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          Cullen Roche Posted by Cullen Roche
          Answered on 04/30/2017 12:11 PM
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            Dividends isn’t a factor or Smart Beta per se, its an income play. As Meb has pointed out elsewhere, it’s also a derivation of the value factor that gets hobbled by taxes.

            I don’t follow Meb anymore, but great link, Roche! I’ve always thought that outperformance chart from Ned Davis was extremely compelling, but now I’m glad it hear it was all B.S.. Never could understand the disconnect between dividend growth and how everyone else invests. At this point — unless it is B.S. too — the only thing that may make sense may be the highest yields in the bottom 33% of payout ratios.

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            Posted by MachineGhost
            Answered on 05/02/2017 5:37 PM
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