This article is part of a regular series on thought leadership from some of the more influential ETF strategists in the money management industry. Today's article is by Corey Hoffstein, co-founder and chief investment strategist of Boston-based Newfound Research.
In Norse mythology, Fimbulwinter is a great and seemingly never-ending winter. It is a time of bitter cold, where hope is abandoned and discord reigns. It’s eventually punctuated by Ragnarok, a series of events leading up to a great battle that results in the destruction of the cosmos, and subsequent rebirth of the world.
Investment mythology is littered with Ragnarok-styled blowups, and we often assume the failure of a strategy will manifest as sudden catastrophe. In most cases, however, failure may more likely resemble Fimbulwinter: a seemingly never-ending winter in performance with returns blown to and fro by the harsh winds of randomness.
Value investors can attest to this. In particular, the disciples of price-to-book have suffered greatly as of late, with “expensive” stocks having outperformed “cheap” stocks for more than a decade. The academic interpretation of the factor sits nearly 25% below its prior high-water mark seen in December 2006.
Is Price-To-Book Broken?
Expectedly, a large number of articles have been written about the death of the value factor. Some question the factor itself, while others simply argue that price-to-book is a broken implementation.
But are these simply retrospective narratives, driven by a desire to have an explanation for a result that has defied our expectations? Consider: If price-to-book had exhibited positive returns over the last decade, would we be hearing from nearly as large a number of investors explaining why it is no longer a relevant metric?
To be clear, we believe many of the arguments proposed for why price-to-book is no longer a relevant metric are quite sound. The team at O’Shaughnessy Asset Management, for example, wrote a compelling piece that explores how changes to accounting rules have led book value to become a less relevant metric in recent decades.
Nevertheless, we think it is worth taking a step back, considering an alternate course of history. Often, we look back on history as if it were the obvious course. “If only we had better prior information,” we say to ourselves, “we would have predicted the path!” Rather, we find it more useful to look at the past as just one realized path of many that could have happened. Randomness happens.
The poor performance of price-to-book can just as easily be explained by a poor roll of the dice as it can by a fundamental break in applicability. In fact, we see several potential truths based on performance over the last decade:
- This is all normal course performance variance for the factor.
- The value factor works, but the price-to-book measure itself is broken.
- The price-to-book measure is overcrowded in use; thus, the “troughs of sorrow” will need to be deeper than ever to get weak hands to fold and pass the alpha to those with the fortitude to hold.
- The value factor never existed; it was an unfortunate false positive that saturated the investing literature and broad narrative.
The problem at hand is twofold: First, the statistical evidence supporting most factors is considerable; second, the decade-to-decade variance in factor performance is substantial. Together, you run into a situation where a mere decade of underperformance likely cannot undue the previously established significance.
Just as frustrating is the opposite scenario. Consider that these two statements are not mutually exclusive: Price-to-book is broken, and price-to-book generates positive excess return over the next decade.
In investing, factor return variance is large enough that the proof is not in the eating of the short-term return pudding.