These Tools for Picking Stocks Sometimes Even Work

Like stocks that have low price-to-earnings ratios? How about ones that have outpaced the market? Or shares of small companies? Those are known as factors: quantifiable characteristics that some money managers use to identify stocks associated with above-market returns. But factor investing is tricky. Sometimes it pays; other times it doesn’t. Bloomberg Opinion columnists Nir Kaissar and Noah Smith recently met online to debate whether factor investing is worth the effort. They previously discussed corporate debt.

Nir Kaissar: It’s widely acknowledged that some factors have historically outpaced the broad market.   

For example, companies that are cheap relative to earnings, cash flow or book value have beaten the market during the past six decades. The same is true of small companies and highly profitable ones.

In a 2017 paper titled “Replicating Anomalies,” economists Kewei Hou, Chen Xue and Lu Zhang identified 67 factors that have produced statistically significant outperformance from 1967 to 2014. In other words, the success of those factors most likely isn’t attributable to chance.   

Seeing an opportunity, fund companies have rolled out a dizzying variety of factor funds in recent years. Investors have poured $762 billion into exchange-traded funds that track factor indexes, according to Bloomberg Intelligence. That’s up from $98 billion at the end of 2007.  

But the question is whether factor investing will continue to pay. Many investors are skeptical. Returns for value investing, arguably the best-known factor, have lagged the market for more than a decade. Meanwhile, broad market indexes such as the Standard & Poor’s 500 Index, which have no meaningful factor exposure, have been among the best performers.

The answer may depend on why factor investing has been profitable in the first place: Is it compensation for taking additional risk or an opportunity to exploit other investors’ mistakes? It’s a hotly debated question, and it relates not only to factor investing, but to how the markets work more generally.  

Noah Smith: I think there are two main questions about factor investing, and you’ve already touched on both.

The first question is what these factors are. Why did things like value, size and momentum show outsized returns for so many decades? Efficient-markets theory says that these outsized returns represent compensation for taking risk — for example, that small stocks sometimes crash even when the market as a whole is not crashing.

As asset manager Cliff Asness has pointed out, that interpretation sort of makes sense for factors like size and value that represent long-term characteristics of companies. But for momentum, it doesn’t really make sense — companies that have high momentum one year often have low momentum the next. It looks like the momentum premium is simply free money, the product of some enduring market inefficiency. This question is important because investors deserve to know whether factor investing is actually increasing their risk, or whether they’re beating the market.

The second question is how long factors persist. You’ve already noted that the value premium has been shrinking over time. But a lot of factors decay even faster. A 2015 paper by economists R. David McLean and Jeffrey Pontiff found that when academics publish a paper about a factor, it tends to shrink or disappear shortly afterward. But a factor tends to hold up between the time they’re discovered and the time the paper is published, implying that the disappearance isn’t a result of publication bias. Instead, this suggests that the market is full of small inefficiencies, which academics and investors are constantly discovering and correcting, and which temporarily manifest themselves as factors.

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Surge of Inflation Isn’t a Guaranteed Portfolio Wrecker

Alan Greenspan, chairman of the Federal Reserve from 1987 to 2006, sent a shiver through investors last week.

In an interview on “The David Rubenstein Show: Peer-to-Peer Conversations” on Bloomberg TV, Greenspan warned that the U.S. may be poised for a period of stagflation, a rare combination of high inflation and high unemployment.

The U.S. last experienced such an episode in the 1970s and early 1980s, and the memory still haunts those who lived through it. The annual inflation rate jumped to 9.8 percent in 1980 from 2.9 percent in 1972, according to the core PCE price index, a measure of personal consumption expenditures excluding food and energy and the Fed’s preferred inflation gauge. Meanwhile, the unemployment rate swelled to 10.8 percent in 1982 from 3.5 percent in 1969, according to the Bureau of Labor Statistics.

For members of Generation X — which includes me — and subsequent generations, stagflation is ancient history. Annual inflation hasn’t topped 3 percent since 1993 and has averaged just 1.8 percent since then. And the current unemployment rate of 3.7 percent is the lowest since 1969.

Still, the implications for investors of skyrocketing inflation and unemployment come quickly to mind. According to lore, a surge in inflation would lift interest rates, causing bond prices to decline and thereby wrecking bond portfolios. Higher interest rates would also thump stock prices because future corporate earnings would be worth less when discounted at higher rates. And all of that would come when many investors would lean on their savings to offset higher living costs and possible bouts of unemployment.

It’s not clear, however, how much of that received wisdom is reliable. Yes, when inflation creeps up, interest rates tend to follow. The correlation between annual inflation and the yield on 10-year Treasuries has been strongly positive (0.76) since 1959, the first year for which numbers are available for the core CPE price index. (A correlation of 1 implies that two variables move perfectly in the same direction, whereas a correlation of negative 1 implies that two variables move perfectly in the opposite direction.)

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Pension Funds Should Think Twice About Alternatives

High-performing alternative investments are great if you can find them, but pension plans shouldn’t count on it.

The Pew Charitable Trusts recently published its latest report on the investment practices and performance of the 73 largest state public pension funds as of the 2016 fiscal year. The big development is that pension funds are moving their money from stocks to alternatives such as private assets and hedge funds. The average allocation to alternatives more than doubled to 26 percent in 2016 from 11 percent a decade earlier, with a roughly equal percentage leaving stocks.

In an accompanying blog post, Pew warned that the move to alternatives would result in more volatility and higher fees for pension funds. Writing for Bloomberg Opinion, investor Aaron Brown took the opposite view last week, arguing that alternatives dampen volatility and boost performance, even after accounting for fees.

Neither view is entirely right. And with an estimated $1 trillion in state and local public pension funds invested in alternatives, and the retirement of 19 million current and former state and local employees at stake, decision makers rushing into alternatives should be clear about what they’re buying.

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A Bull Market Quandary: Your Clients or Your Convictions

The U.S. stock market is dominating again this year, and money managers may soon face some unpalatable choices.  

It’s not even close. The S&P 500 Index is up 9.9 percent in the eight months through August, including dividends. Meanwhile, overseas stocks, as measuredby the MSCI ACWI ex-USA Index, are down 3.2 percent. U.S. bonds, as represented by the Bloomberg Barclays U.S. Aggregate Bond Index, are down 1 percent. And hedge funds, as tracked by the HFRI Fund Weighted Composite Index, are up a modest 1.7 percent.

It’s too soon to know how private assets, such as venture capital, private equity and real estate, have done because their results are generally reported on a multi-month lag. But it’s not likely to matter. Even the most ardent admirers of private assets, such as elite university endowments, allocate only a portion of their portfolios to them. So the results, however good, are unlikely to make up for the drag from other assets.

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It’s Not Time to Hit the Ejector Seat on Emerging Markets

This is no time to panic about emerging markets.

Imagine you hadn’t read the headlines about emerging markets this week. You didn’t know that South Africa slipped into a recession, or that the currencies of Turkey, Argentina and Indonesia are near record lows, or that seemingly every emerging-market analyst predicts that the trouble will spread to other developing countries.

Instead, all you would have are the numbers showing how emerging-market stocks have behaved in the past. You would see that the MSCI Emerging Markets Index returned 8 percent annually in dollars since 1988 through August, excluding dividends, and that the volatility, as measured by annualized standard deviation, was 23 percent during the period.

You would quickly deduce that emerging-market stocks are a wild ride. The EM index can be expected to decline more than 40 percent of the time and enter bear market territory — a decline of 20 percent or more — close to a third of the time. You would then notice that the EM index has fallen by 19.7 percent in dollars from its peak on Jan. 26 through Wednesday and most likely conclude that nothing unusual was happening.

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Mid-Cap Stocks Aren’t Ready for a Starring Role

I can’t open a web browser lately without seeing a banner promoting State Street Corp.’s new digital series “Crazy Enough to Work” starring actress Elizabeth Banks — who, I must confess, I think is fabulous.

The series profiles four midsize companies. The first two episodes showcase EPR Properties and the New York Times Co. and have already been released. The final two feature Dunkin’ Brands Group Inc. and the Boston Beer Co. and will be available on Aug. 29 and Sept. 12, respectively.

It’s all a plug for State Street’s SPDR S&P MidCap 400 ETF, which makes me wonder about those algorithms supposedly customizing my online experience. I’ve never expressed any interest in buying a mid-cap stock fund.

It’s not that I have anything against mid-caps. On the contrary, I own them like nearly everyone else. I’m defining mid-caps as stocks with a market value of $1 billion to $10 billion. If you own a large-cap stock fund, chances are you own some mid-caps, too.

Consider that there are 458 mid-cap stocks in the Russell 1000 Index, which collectively make up 8.9 percent of the index. Mid-caps make up an even bigger chunk of the broader market. There are 1,429 mid-caps in the Russell 3000 Index, accounting for 14.6 percent of the index.

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Stock Investors Pick the Wrong Exit in Emerging Markets

Here’s a brainteaser: While investors fret about trade wars and rate hikes, U.S. stock prices keep climbing.

Answer: Investors are indeed running for the exit — just through the wrong door.

Emerging-market stocks, not those in the U.S., are taking the brunt of investors’ fears. The MSCI Emerging Markets Index is down 7.7 percent this year through Wednesday, while the S&P 500 Index is up 5.3 percent. The EM index is also down 16 percent from its high on Jan. 26, just shy of the 20 percent decline that signals a bear market.

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Target-Date Funds Aren’t the Retirement Bull’s-Eye

The Vanguard Group published recently its “How America Saves 2018” report, a trove of data on more than 4.9 million retirement savers in 401(k)s, 403(b)s and other defined-contribution plans.

My colleague Barry Ritholtz has already noted many of the highlights, but one detail deserves more exploration: Target-date funds are taking over retirement accounts.

The numbers are astonishing. Roughly half of retirement savers invested their entire account in a single target-date fund in 2017. None did so as recently as 2004. Vanguard estimates that number will grow to 70 percent by 2022.

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Pretty Soon, You’ll Get to Invest Just Like Ray Dalio

Ray Dalio may be slowing down, but the investment strategy he popularized is just getting started.

Bloomberg News reported recently that Dalio, founder of the world’s largest hedge fund, Bridgewater Associates LP, will spread the firm’s ownership among more employees and give them a say about management and governance.

Dalio founded Bridgewater in 1975, but he will most likely be remembered for the All Weather fund the firm launched more than two decades later in 1996. That fund was the first to offer a strategy that has come to be known as “risk parity.”

Investors may not yet be familiar with risk parity, but that’s about to change. Putnam Investments introduced a risk parity mutual fund last year. Robo-adviser Wealthfront Inc. launched one this year and added it in February to accounts with more than $100,000 in taxable assets, raking in $780 million for the fund so far, according to Morningstar. More funds are likely to follow.

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Trade War Would Cause Trouble on Home Front for U.S. Investors

President Donald Trump’s looming trade war is no friend of the U.S. stock market, and that’s bad news for U.S. investors who like to keep their money at home.

Free trade is under siege. The White House imposed $50 billion in tariffs on Chinese imports on Friday. China responded in kind. President Trump is now threatening up to $400 billion in additional tariffs, and China is vowing to retaliate again. Its Ministry of Commerce called for “comprehensive quantitative and qualitative measures” if the U.S. imposes additional tariffs.

The intensifying trade dispute should worry investors who are reluctant to venture overseas, and there are many of them. According to one estimate, U.S. investors, on average, allocate just 15 percent of their stocks to foreign markets. That’s a huge home bias given that the U.S. accounts for roughly half of global stocks by market value and a quarter of the world’s economic output.

Proponents of home bias argue that U.S. stocks provide plenty of exposure to foreign markets because large U.S. companies sell their wares all over the world. The percentage of S&P 500 sales from foreign countries was 43.2 percent in 2016, according to S&P’s most recent global sales report. That percentage has been reliably between 43 percent and 48 percent since 2006.

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