Professor Has Some Questions About Your Index Funds

Lu Zhang, a finance professor at Ohio State University, has something to say about your hot new index funds, and it may not be flattering. 

Not long ago, the typical investment portfolio was a grab bag of stocks, bonds and actively managed mutual funds. Today, it is more likely an assortment of index funds. And not just any index funds. Indexes are no longer content to simply track the market. A growing number of them are attempting to replicate traditional styles of active management, also known as “factors.” I counted roughly 900 mutual funds and exchange-traded funds in the U.S. that track factor indexes, and that number is likely to grow.  

The pivot to indexing may be new, but it was cultivated by decades of research in economics and finance, which gives it the imprimatur of science, or at least robust inquiry. But a new generation of academics, Zhang prominently among them, are re-examining the research and finding much of it questionable. Their work could derail the indexing revolution and, as might be expected, index providers and fund companies aren’t likely to be happy about it.   

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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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Investors Deserve a Peek at Bond Managers’ Tricks

Active bond managers have dazzled investors by outpacing the bond market in recent years. But it’s a simple sleight of hand, and the big reveal is coming.    

The trick is that bond managers have been quietly loading up on low-quality bonds. They pay a higher yield than top-quality ones to compensate for their greater risk of default — in technical parlance, a credit premium.

When times are good, as they have been in recent years, there are few defaults because borrowers have little trouble paying their debts. Bond managers collect their credit premiums and easily beat the broad bond market indexes, which tend to be dominated by high-quality bonds.

When the economy slows, however, the defaults start to pile up, handing losses to holders of low-quality debt. And suddenly bond managers don’t look so smart.  

It’s a worthwhile trade-off for managers. The booms normally last longer than the busts, which means that credit premiums are usually a boost to performance. And nothing attracts investors like a hot hand, or the appearance of one.

But it’s not great for investors. They often don’t realize that their bond manager is taking more risk until the losses show up. And investors who want riskier bonds can almost always buy them more cheaply through index funds. They would be better served by a closer inspection of bond managers’ tricks of the trade.

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Value Versus Growth Plays Out in Emerging Markets

Emerging markets are flashing warning signs, but don’t tell that to value stocks.

The MSCI Emerging Markets Index is down 19.2 percent from its recent high on Jan. 26 through Friday as investors wring their hands over tariffs, slow growth, a rising dollar and numerous other fears.

To some investors’ surprise, value stocks are holding up better than growth. The MSCI Emerging Markets Value Index is down 18.3 percent, while the MSCI Emerging Markets Growth Index is down 20.1 percent.

In theory, that’s not supposed to happen. Value stocks, after all, are cheaper than growth for a reason: They represent companies, and sometimes whole sectors, that have fallen on hard times or are struggling to grow — think banks and brick-and-mortar retailers. Those problems are compounded in a downturn. And as goes the business, so goes the stock.

But in reality, stocks haven’t always followed that playbook, at least in the U.S. I counted 13 U.S. bear markets since 1926, as defined by a decline of 20 percent or more in the S&P 500 Index for the longest period for which numbers are available. I’m also counting the periods from September 1929 to March 1935 and from March 1937 to April 1942 as a total of two bear markets.

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Dance of Investing Styles Doesn’t Signal a Downturn

The U.S. stock market notched yet another record on Wednesday, and many investors are anxiously looking for signs of a slowdown.

Perhaps not coincidentally, researchers at Sanford C. Bernstein & Co. say they’ve spotted one. According to Bloomberg News, Bernstein has found that correlations among investment styles — or factors — such as value and momentum “have shot to all-time highs.”

That means they are moving in the same direction, and that is apparently a bad omen. As Joseph Mezrich, managing director at Nomura Securities International Inc., told Bloomberg, “In the past factor correlation has tended to rise in periods of macro stress.”

The concern is likely to interest more than just wary investors. Factor investing is increasingly popular. Investors have poured $352 billion into value, momentum, quality and other factor exchange-traded funds since 2013, according to Bloomberg Intelligence, nearly double the $191 billion in factor ETFs at the end of 2012.

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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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FAANGs Are More Solo Acts Than a Tech Supergroup

It’s time for FAANG stocks to break up, at least in investors’ minds.

Facebook, Apple, Amazon, Netflix and Google parent Alphabet can’t get away from one another. Every time one grabs the spotlight —  as Apple did last week when it became the first  U.S. company with a $1 trillion market value — it brings along the other four.

They’re alternately hailed as the hot stocks, technology’s brightest lights and indispensable growth companies, and jeered as a worrisome sign of a frothy and top-heavy market. But look closely and it’s no longer clear why they should be lumped together at all.

Let’s start with the technology moniker. Amazon is a retailer and Netflix is an entertainment company, which is why, contrary to popular perception, the Global Industry Classification Standard, or GICS, tags them as consumer discretionary companies, not tech. And as of the next GICS reclassification in September, Facebook will move from the tech sector to telecommunications, where it belongs. Only two of the five FAANGs, in other words, are true technology companies.

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Funds Like Magellan Need Gamblers Like Bill Gross

I know why investors don’t care about Fidelity Magellan’s comeback.

As Bloomberg News reported on Monday, the mutual fund made famous by hall-of-fame stock picker Peter Lynch is enjoying a resurgence after years of mediocre performance. The fund fell into a “15-year funk” after Lynch’s successor, Jeffrey Vinik, left in 1996. But ever since current manager Jeffrey Feingold took over in September 2011, “Magellan has bested the S&P 500 index every full year but 2016.” The fund has also “outdone more than 90 percent of funds with a similar investing style over the past one, three, and five years.”

Despite Feingold’s apparent success, however, investors are yanking money from the fund. The knee-jerk explanation is that investors have lost faith in active management, no matter what the results. A more accurate one is that investors no longer need the vast majority of actively managed funds, including Magellan.

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Investors Can Miss the Forest for the Smart Beta Trees

A battle is raging among finance theoreticians, and investors should stay out of it.

There’s a growing recognition that a handful of active investing styles — also known as factor investing or smart beta — can be expected to beat the market over time. Among them are value (buying cheap stocks), quality (buying profitable and stable companies), momentum (following the trend) and size (buying small companies).

The evidence is compelling. The cheapest 10 percent of U.S. stocks — sorted on price-to-book ratio and then weighted by market capitalization —  returned 11.9 percent annually from July 1926 through March, including dividends, according to numbers compiled by Dartmouth professor Kenneth French. That’s 1.8 percentage points a year better than the S&P 500 Index during those nine decades and 3.1 percentage points a year better than the most expensive 10 percent of stocks.

Value also won over shorter periods. The cheapest 10 percent of stocks beat the S&P 500 roughly 72 percent of the time over rolling 10-year periods, and they beat the most expensive 10 percent of stocks 73 percent of the time.

The results are similar for stocks sorted on profitability, momentum and size.

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Hedge Funds No Longer Need the Star System

Hedge funds’ brightest lights have fallen on hard times, but don’t shed a tear for the industry just yet.

The list of once-revered-now-humbled hedge fund managers is growing. Alan Fournier is shutting Pennant Capital Management after nearly two decades, acknowledging that “recent returns have been disappointing.” David Einhorn’s main hedge fund at Greenlight Capital was down 14 percent in the first quarter  after a decline of 4.1 percent annually from 2015 to 2017. Pershing Square Capital Management’s Bill Ackman calledhis recent returns “particularly unsatisfactory,” and investors apparently agree. Ackman’s assets under management shrank to $8.2 billion as of March from $18.3 billion in 2015.

Despite the travails of star managers, however, the hedge fund industry is doing fine. The HFRI Fund Weighted Composite Index returned 0.3 percent during the first quarter, compared with a negative 0.8 percent for the S&P 500 Index, including dividends.

Granted, hedge funds haven’t kept pace with the stock market in recent years, but they’ve fared better than many of the stars among them. The HFRI index has returned 4 percent annually from 2015 through March, compared with 10.2 percent for the S&P 500.

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