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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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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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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Vanguard Disrupted Active Investing. Now It Could Save It.

Indexing pioneer Vanguard Group may be stock pickers’ last hope.

Investors are increasingly turning their stock picking over to computers. So-called smart beta exchange-traded funds track indexes that replicate traditional styles of active management such as value, quality and momentum. Investors handed $184 billion to smart beta ETFs from 2015 to 2017 while pulling $308 billion from equity mutual funds, according to data compiled by Bloomberg Intelligence.

It’s not surprising. Smart beta ETFs are cheaper, and investors are skeptical that human stock pickers can beat the bots by more than the difference in fees. According to Morningstar data, the average expense ratio for smart beta ETFs is 0.47 percent a year, and the asset-weighted average expense ratio — which accounts for the size of the ETFs — is just 0.26 percent. That compares with 1.13 percent and 0.7 percent, respectively, for actively managed mutual funds.

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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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Investors Resist Golden Age of Active ETFs

ETF enthusiasts gathered recently in Hollywood, Florida, for the “Inside ETFs” conference, the industry’s biggest party of the year. By many accounts it was the swankiest celebration yet.

And for good reason. When Inside ETFs first convened in 2008, ETFs managed $500 billion, or one-twentieth of the money managed by mutual funds, according to Broadridge. ETFs now oversee $3.4 trillion, or one-fifth of mutual fund assets, according Morningstar data.

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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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