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What if There Are no Reliable Factors?

I’ve always been bothered by the notion of “factor investing”. In case you don’t know, factor investing is derived from Eugene Fama’s various factor models (which have expanded over time to account for increasing inconsistencies in the Efficient Market Hypothesis). Fama started with 1 factor to explain the market’s movements, expanded it to 3, then 5 and who knows what’s next. Others have already discovered hundreds of so-called “factors” so the story seems to keep getting crazier and crazier.  At least by now we know that the EMH is a lot less useful than Fama originally thought yet the model keeps getting tweaked and expanded.

When you understand my view on the active vs passive debate the EMH becomes an almost entirely useless concept.  In fact, I am almost certain that the EMH is little more than the Chicago School’s version of a finance argument against the use of discretionary intervention in a portfolio grounded in a political ideology. This was a theoretical view which would have created a theory of finance that was consistent with their anti discretionary theory of economics, Monetarism. While the econ theory has collapsed, the finance theory has prospered, which is quite curious.

Of course, as I’ve noted time and time again, we all make discretionary decisions about our portfolios over time. In fact, there is nothing that is truly “passive” about portfolio management and I think that stock pickers have been strawmanned to death by index picking advocates who don’t fare any better against a global aggregate.  In fact, even Vanguard has shown that the active share of a fund isn’t the key determining component of underperformance yet the entire industry still refers to “active vs passive” when it’s really all about high fee vs low fee.  Worse, “factor” investing is little more than another term for active investing by picking broad swaths of the markets inside of an aggregate and then labeling it “passive”.  This often looks like good marketing more than sound analysis.

All of this makes me deeply skeptical about Fama’s various factors and whether anyone should actually invest according to these factors. After all, you might know that certain factors tend to perform well, but you still have to be able to pick the various assets that will actually adhere to these factors over time. Plus, you have to time that performance correctly because we know that all factors don’t always work.  For instance, the concept of value has led countless investors astray in recent decades. How many indexers have tried to value the markets using something like Shiller’s CAPE ratio only to find out that stocks can become increasingly and seemingly permanently overvalued?  Or what about momentum?  The biggest adherents of this strategy, managed futures funds, have been burned for years running now.  And Ben Carlson notes that small caps only outperform large caps because of an 8 year period of performance.

It seems to me like Fama couldn’t quite fit his square peg in a round hole. So he shaved off the corners and called them “factors” and then convinced the world that these were ironclad laws of the markets. Worse, he convinced people that tilting towards these “factors” wasn’t another version of “active” investing yet firms like DFA have made billions charging people high fees for active funds by another name.  Fama once said that good academic work is “50% marketing”.  Sometimes I wonder if all this factor talk isn’t 100% marketing….