Bernstein: Bozos Make Smart Beta Work

March 17, 2014

Factor-focused investing will always work because of the mistakes so many investors inevitably make, Bill Bernstein says.

Given the increased popularity of factor-based investing these days, one wonders that if everyone is chasing a value premium or small-cap premium, won’t the trade just stop working? That may be theoretically true, but investor mistakes assure that factor-focused investing will always work, according to Bill Bernstein, author and steadfast advocate of passive investing.

Bernstein told Managing Editor Olly Ludwig that because so many investors jump into the fray too late and because so many bail out of the markets at the first sign of trouble, the stock market will always reward those who keep their wits about them, whether they’re pursuing newfangled factors first isolated by Eugene Fama or Kenneth French, or just plain-vanilla beta. In all this factor trendiness, what even qualifies as a bona fide “factor”?

Bernstein: In the first place, you’ve got to be sure that you’re looking at something that, ex-post, is legitimate. So you do what anybody who looks at things systematically has to consider: Do you see it in more than one time period or in more than one country? So if it’s present in multiple 20-year time periods across most national markets, then it’s legitimate.

Fama and French, for example, when they first data-mined the CRSP data base, it was just one country, and 1962 to 2000, or whatever. And they went back, looking from 1926 to 1962, and it was still there—and both the factors were in all but one developed nation.

And over a relatively short period, the factors were in 12 of 16 emerging market nations. The thing about the emerging market data is that even though it was “negative” in four of the emerging market nations, overall it was spectacularly positive. With the DFA emerging value and emerging market small-cap funds, the premium is very big on those two factors in emerging markets. To be painfully obvious, the two factors Fama and French isolated were what?

Bernstein: It’s just small-cap and value. Those were the only two factors they had time to look at. The other two factors or three factors that people look at are profitability and momentum. And then, of course, there’s low volatility—the question is: Is that a legitimate factor?

Because, the trick is that once you apply all the other factors, low volatility pretty much disappears. Not only that, but you can make a good case that low vol is a systemic risk factor, so there’s some question as to just how legitimate low vol is.

There’s no question momentum is a factor. And profitability? It’s probably a factor too.


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