The Intelligent Investor
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What's Wrong With Dumb Beta?
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Good afternoon.
Not long ago, investors could try to beat the market or just be the market. If you had hopes of outperforming, you'd pick your own stocks or hire a manager to do it for you. Otherwise, you'd buy an index fund and settle for matching the market.
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More recently, people have been trying to beat the market without picking stocks or managers. So-called smart-beta funds often own hundreds of stocks, all with a common characteristic to which researchers have attributed superior returns. ("Beta," originally a technical term for an asset's riskiness relative to the market, has come to stand for the market itself.) Among the factors that researchers have identified as having had high returns are...
...and many more. A survey of the research found last year that roughly 400 such factors have been identified:
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Campbell R. Harvey and Yan Liu, "A Census of the Factor Zoo," ssrn.com
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For almost every factor, it seems, there's a fund. ETFGI, a London-based research firm, reports that 1,351 smart-beta ETFs commanded nearly $820 billion in assets worldwide as of the end of July.
Some factors seem too general (when companies announce their earnings), others too specific (whether the spread between companies' one-year and five-year credit-default swaps is positive).
Some factors seem to make good sense, but they can't all work over time, and none of them can work all the time.
As portfolio manager Pim van Vliet pointed out in my column last weekend, holding low-volatility stocks is like “going to a party and standing there with your soda while everybody else is drinking liquor and jumping up on the tables to dance." Nobody likes being “the boring guy,” as he put it. The short-term boredom can depress prices, leading to superior returns in the long run — but the long run can be discouragingly long.
The value factor hasn't worked well in at least a decade. Properly measured, size might never have worked, fund manager Cliff Asness argued in a blogpost last week.
In fact, only momentum and quality, among the major factors, have done well so far this year:
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Matthew J. Bartolini, SPDR Blog
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"The microburst of volatility [in February and March] was so violent and swift that it became a selloff where everything moved in tandem," says Matthew Bartolini, head of SPDR Americas research at State Street Global Advisors.
Investing in a factor fund, or a combination of them, isn't a bad idea as long as the underlying research is sound, the fund is well designed and the expenses are low. But believing that smart-beta funds will always work or will beat the market by a huge margin? That is a bad idea.
After all, you can always invest in dumb beta with no effort and almost no cost by buying a plain old index fund. The attempt to do even a little better takes a lot more work — more than many investors often realize.
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Rosa Bonheur, "Plowing in the Nivernais" (1849), Musee d'Orsay via Wikimedia Commons
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Be well and invest well,
Jason
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This Week in Financial History
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Sept. 23, 1998: In what The Wall Street Journal calls a "massive bailout of a stricken hedge fund...to save capitalism from itself," 15 leading investment banks chip in a total of $3.5 billion to bail out Long-Term Capital Management L.P.
Sept. 24, 1869: On Wall Street's first "Black Friday," financier Jay Gould's attempt to corner the gold market fails, as the price falls from more than $160 to less than $135 in minutes, wiping out many lesser speculators.
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Photograph showing blackboard marked with intraday gold prices Sept. 24, 1869 (Library of Congress)
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Sept. 24, 1917: The second Liberty Loan Act authorizes the U.S. Treasury to issue more debt to fund World War I. In a stroke of genius, the Treasury creates 25-cent savings stamps that citizens buy at post offices and banks, then affix to a card. After filling a card with 16 stamps, they trade it for a baby bond that pays $5 at maturity in 1923. The program raises $1.6 billion, nearly 5% of the war's cost — and prompts Wall Street to create retail “salesforces” to turn American families into investors.
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Sept. 27, 1829: A train carries passengers for the first time as George Stephenson's "Rocket" hauls a heavy load of freight -- and some 600 excited passengers — almost 21 miles in just over four hours, an astonishing pace of 5mph. Within a few years, railroads would girdle much of the world — although investors who overpaid for railway stocks would be sorry.
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Some Stories You Shouldn’t Miss
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Here are some of the best things I found over the past week outside The Wall Street Journal:
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It is harder — and more important — than ever to focus your mind on "thinking in thoughtless times," advises portfolio manager Frank Martin
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In defiance of conventional wisdom, investors may take more risk as they age, not less, warns the Finra Investor Education Foundation
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The stock market's winner-take-all problem is worsening, with companies like Amazon squeezing out more competitors, argues Sparkline Capital
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Was the long-term superiority of value investing just an illusion? After a thoughtful pause, portfolio manager Drew Dickson says: probably not
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A great primer on inflation-protected bonds and their importance in portfolios from Movement Capital
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You don't say: CEOs and CFOs who tried to cover up cheating on their spouses were also more likely to have to restate their companies' financial reports, a research paper finds
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Yes, animals have consciousness — and much more than most people recognize, says a team of British researchers
Here are some of the best things I read recently in The Wall Street Journal:
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Q:
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Good morning Jason,
Any advice on how to explain the complexity of investing/trading in one breath? — Jeffrey Abalos, San Diego
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A:
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The Talmud says a man once came to the great rabbi Hillel and said: "Teach me the entire Torah while I stand on one foot." Hillel replied: "Do not do unto others what you would not have them do unto you. All the rest is commentary."
Years ago, I asked a bunch of leading investors if they could summarize their investing philosophy in no more than 10 words.
I got some excellent responses from such luminaries as Jack Bogle, Rob Arnott, Bill Miller and William Bernstein. You can see their replies, none longer than 10 words, here.
Naturally, people challenged me to come up with my own version. Inspired by similar wording from a reader named Lorenzo, I finally settled on this:
Open your mind, close your heart.
That combines two important ideas: 1) Every investor should seek out all relevant evidence, especially any that could disprove your ideas; 2) At the same time, you should work hard to prevent other people’s emotions from tainting your judgment.
That doesn't mean you should be callous or hard-hearted. It simply means you shouldn't let the fear or greed or folly of others shape your attitudes and behavior.
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Augusta Savage, "The Harp" (1939), Schomburg Center for Research in Black Culture, The New York Public Library
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I won't be doing a newsletter next week. Talk to you again on Oct. 6th.
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If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.
— Benjamin Graham
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