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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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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Bring Harvard and Yale Investing to the People

Lots of people want to invest like elite university endowments, but securities laws don’t allow it. It’s time to remove those barriers.

But it’s worth asking whether investors should aspire to the so-called endowment model in the first place. According to numbers compiled by the National Association of College and University Business Officers, universities with the biggest endowments generated an average return of 9.7 percent annually over the last 30 years through June 2017 — the longest period for which annual returns are available — slightly edging out the S&P 500 Index’s return of 9.6 percent, including dividends.

Admirers of the endowment model are quick to point out that it’s less volatile than the stock market. The better comparison, they say, is a traditional 60/40 portfolio of stocks and bonds. That mix, as represented by the S&P 500 and the Bloomberg Barclays U.S. Aggregate Bond Index, returned just 8.6 percent over those three decades, or 1.1 percentage points a year less than endowments.

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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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Warren Buffett Is Even Better Than You Think

Warren Buffett is an even better investor than you think.

The Oracle of Omaha released his latest annual letter to shareholders of Berkshire Hathaway Inc. on Saturday. It’s a good excuse to marvel anew at Buffett’s track record, particularly at a time when stock pickers are losing their aura.

Buffett famously likes to invest in companies that are highly profitable and selling at a reasonable price. That formula has routinely beaten the market, according to University of Chicago professor Eugene Fama and Dartmouth professor Kenneth French.

The Fama/French US Big Robust Profitability Research Index — which selects the most profitable 30 percent of large-cap companies — beat the S&P 500 Index by 1.2 percentage points annually from July 1963 to 2017, including dividends, the longest period for which returns are available. The profitability index also beat the S&P 500 in 81 percent of rolling 10-year periods.

Similarly, the Fama/French US Large Value Research Index — which selects the cheapest 30 percent of large-cap companies — beat the S&P 500 by 2.3 percentage points annually from July 1963 to 2017, and in 82 percent of rolling 10-year periods.

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Vanguard Should Get Active

As my Bloomberg News colleagues reported earlier this week, the financial juggernaut known as Vanguard added $185 billion to its low-cost and passively-managed funds so far this year, “which puts it on pace to…” wait for it, wait for it, “…bring in more money in one year than any asset manager in history.”

Vanguard deserves its success. It’s brought low-fee, principled investing to the masses in a singular and admirable way.

According to Bloomberg, the average asset-weighted fee of a Vanguard fund is 0.13 percent, compared with 0.66 percent for an active mutual fund. On $185 billion, this translates into fee savings of nearly $1 billion this year alone – a boon to Vanguard’s legions of investors.

But as the industry leader, there’s much more that Vanguard could and should do.

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