Bernstein: Bozos Make Smart Beta Work

March 17, 2014 How do you distinguish between profitability and momentum? They seem like cousins.

Bernstein: There’s some overlap, I think; though, truth be told, I haven’t looked at the series.

But there are two difficulties in implementing any of these strategies. No. 1 is that if the bozos know about it, it doesn’t work anymore. In fancier language: Is it getting arbitraged away, which is the real question you’re asking. And the best answer I can give you is, partially.

But I don’t think these factors will ever get completely arbitraged away. Because what will happen is you get a lot of “dumb money” signing on, and then, as in 2008 and 2009, small-cap and value didn’t do very well. And people said: “This doesn’t work anymore!” So during the crisis, all kinds of these funds dried up. Are you saying that dumb investor behavior, investors bailing out at the wrong time, is actually a saving grace for the viability of these factors?

Bernstein: Yes. That’s a factor in everything about investing. This is why plain old beta stock market exposure has a good return too, because dumb money piles into it, and that produces the inevitable popping of the bubble, and people say: “This is risky!” And they sell out, just at the wrong time.

This is the essence of the concept of the limits of arbitrage: Just when the expected risk premium is highest, after it’s been sold to death, that’s when the liquidity available to invest in it is lowest. That’s a setup for a continuation of these factors. If we assume a world where investors are behaving “correctly,” the arbitraging away of these factors would be much more significant and complete?

Bernstein: Yes! And it gets back to that saying—I can’t remember who said it—“Bear markets are when stocks are returned to their rightful owners.” It’s like anything else in investing: The weak hands will lose money and the strong hands will make money. That’s the way it always is. It’s true of stocks and stock exposure, and it’s true of factors as well. And, to review, you consider legitimate the original Fama-French factors of size and value; and you added profitability and momentum and then put a question mark around low volatility?

Bernstein: Right. And what about dividends? Those get wrapped into this factor discussion too. How do you categorize dividends?

Bernstein: That’s value. You can sort value a number of ways, and dividends are a really good way of doing it; price-to-book is a really good way of doing it. Price-to-earnings? Probably not so good. Do you have a sense, as I do, that “factor-focused” investing is reaching some critical mass these days—and that we can see that in the behavior of the Wall Street marketing machine?

Bernstein: I think so. The bozos have jumped into the factors with both feet. And this won’t end well, is what history tells us?

Bernstein: Exactly. They’re not called risk premia for nothing.


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