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. 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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