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.
Size Factor Comparison
The small-cap premium is an excellent example of the difficulty in discerning, in real time, the integrity of an established factor. The anomaly has failed to establish a meaningful new high since it was originally published in 1981. Only in the last decade—nearly 30 years later—have the tides of the industry finally seemed to turn against it as an established anomaly and potential source of excess return.
The remaining broadly accepted factors—e.g., value, momentum, carry, defensive and trend—have all been demonstrated to generate excess risk-adjusted returns across a variety of economic regimes, geographies and asset classes, creating a great depth of evidence supporting their existence.
What evidence, then, would make us abandon faith from the Church of Factors?
Testing Each Factor
To explore this question, we ran a simple experiment for each factor. Our goal was to estimate how long it would take to determine that a factor was no longer statistically significant.
Our assumption is that the features of each factor’s return pattern will remain the same, but the forward average annualized return will be zero since the factor no longer “works.”
Toward this end, we ran the following experiment:
- Take the full history for the factor and calculate prior estimates for mean annualized return and standard error of the mean.
- De-mean the time-series.
- Randomly select a 12-month chunk of returns from the time series and use the data to perform a Bayesian update to our mean annualized return.
- Repeat the previous step until the annualized return is no longer statistically non-zero at a 99% confidence threshold.
For each factor, we ran this test 10,000 times, creating a distribution that tells us how many years into the future we would have to wait until we were certain, from a statistical perspective, that the factor is no longer significant.
Based on this experience, 67 years is the median number of years we will have to wait until we officially declare price-to-book (known as HML) to be dead (we are ignoring historical and forward evidence, or counter-evidence, found in other geographies). At the risk of being morbid, we’re far more likely to die before the industry finally sticks a fork in price-to-book.
We perform this experiment for a number of other factors—including size (“SMB”), quality (“QMJ”), low-volatility (“BAB”) and momentum (“UMD”)—and see much the same result. It will take decades before sufficient evidence mounts to dethrone these factors.
|Median Years Until Failure||67||43||132||284||339|
*Since size is no longer statistically significant at the 1% level, we use the 5% level as the threshold.
It is worth noting that these figures for a factor-like momentum (“UMD”) might be a bit skewed due to the design of the test. If we examine the long-run returns, we see a fairly docile return profile punctuated by sudden and significant drawdowns.
While an evidence-based investor should be swayed by the weight of the data, the fact is that most factors are so well-established that the majority of current practitioners will likely go our entire careers without experiencing evidence substantial enough to dismiss the anomalies.
Therefore, in many ways, there is a certain faith required to use them going forward.
Yes, these are ideas and concepts derived from the data. Yes, we have done our best to test their robustness out-of-sample across time, geographies and asset classes. Yet we must also admit there is a nonzero probability, however small, that these are false positives: a fact we may not have sufficient evidence to address until several decades hence.
So a bit of humility is warranted. Factors will not suddenly stand up and declare themselves broken. And those that are broken will still appear to work from time to time.
The death of a factor will be more Fimbulwinter than Ragnarok—not so violent to be the end of days, but enough to cause pain and frustration among investors.
Newfound is a Boston-based quantitative asset management firm focused on rules-based, outcome-oriented investment strategies. Newfound specializes in tactical asset allocation and risk management solutions. Founded in 2008, Newfound offers a full suite of tactical ETF managed portfolios covering global equity, U.S. small-cap equity, multi-asset income, fixed income and alternative asset classes. For more information about Newfound Research LLC, call 617-531-9773, visit www.thinknewfound.com or email [email protected].