The Value in Factor Investing
I have always found factor investing to make intuitive sense. When it comes to individual company valuations, the concept of Economic Value Add or EVA has always been important to me. Stewart’s The Quest for Value and Copeland’s Valuation are cornerstones of my approach to company valuations. The traditional value “risk” factor is based on a corporation’s relative equity value to book equity value while EVA is focused on the corporation’s enterprise value, which considers all sources of funding corporate activities, and the capital used to earn economic rents.
However, I believe the perspective is lost when we shift from analysis of factors at the individual security level and its extension to the portfolio level and the measurement of portfolio returns at the mutual fund level. As Stephen LeRoy asked in a 1989 paper on efficient markets, “Where does Marshall’s Principles stop and the random walk start?”
There was hope in the 1960s and 1970s that an asset pricing model could bridge that gap. What we saw instead was the birth of behavioral finance in the 1980s. By the 1990s, we saw a shift away from the Capital Asset Pricing Model (CAPM) and towards an ad-hoc factor investing model. This means that while markets might be hard to beat, there is no model based way of knowing whether the price is correct.
Since then, performance measurement utilizing “passive” factor benchmarking have been weaponized in the performance management industry to make the risky argument that portfolio managers do not have skill. Carhart’s 1997 paper pretty much highlights where the broad industry is at today.
Persistence in mutual fund performance does not reflect superior stock-picking skill. Rather, common factors in stock returns and persistent differences in mutual fund expenses and transaction costs explain almost all of the predictability in mutual fund returns.
I believe the argument being made is risky in regards to superior stock-picking skill and not an appropriate approach. Now consider the 2013 paper Buffett’s Alpha by Frazzini, Kabiller, and Pederson. The following is part of the introductory abstract:
Berkshire Hathaway has a higher Sharpe ratio than any stock or mutual fund with a history of more than 30 years and Berkshire has a significant alpha to traditional risk factors. However, we find the alpha become insignificant when controlling for exposures to Betting-Against-Beta and quality factors … Buffett’s returns can thus largely be explained by the use of leverage combined with a focus on cheap, safe, quality stocks.
While the use of the word “insignificant” is eyebrow raising, tell me who subscribed to these “factors” when Warrant Buffett did. Ex-post analysis will always be prone to data snooping and hindsight bias. The value in papers like Buffett’s Alpha (and Buffett’s superior stock-picking skill) isn’t to find new ways to abolish alpha but in understanding “the why” behind investment returns. For instance Buffett’s Alpha highlights the use of low volatility investing (i.e. Betting-Against-Beta) as part of Berkshire Hathaway’s strong performance.
Weaponizing factors by turning them into “passive” benchmarks (ex-post) and making them the premise of the risky argument that mutual fund investment managers lack skill might be good for competing index companies but does nothing to bridge the gap between micro and macroeconomics.