Another Thing That Worked in the Past That Won’t In the Future

Meb Faber, one of my kindred investing spirits, has a new book out. He asked twitter for book title ideas. One of my favorite twitter cynics (@ianjoblingrox) joked that he should name it “another thing that has worked in the past that won’t in the future: mean reversion is a bitch.” I laughed pretty hard at that one. I bet Meb did too.

One of the great challenges for quantitative investors is finding new ideas that haven’t yet reached critical mass. So often, a new factor or category rises to the top of a back-testing pile when it is already too late. Like a ton of others, I started checking out asset class trend following stuff AFTER 2008 (Meb had shrewdly done it well before the crash). This stuff happens all the time.

All of my personal money is invested in value/momentum/shareholder yield strategies. New iterations of these pop up all the time (I do a lot of this testing myself). The market has a cruel sense of humor, though. Beware: whatever idea you are hearing the most about may be overly ripe. I hate even writing this because it’s cliché and self-evident, but the key to winning with these factors (if they are going to keep working) is to stick with them for the long term. This is really hard. Backtests are like diet books: tons of great evidence, studies, and so on. They make it really easy to invest or to cut out gluten. But what about a year later, or two, or three? Some new book (with a new diet or backtest) will appear, and we like the new stuff. The worst thing you can do is style hop, but we always do it because stupid evolution made us impatient performance chasers.

I talk with a lot of people in the investing world, from end investors and advisors, to endowments, pension funds, foundations, and all other kinds of institutions. Everyone is talking about smart beta and factor investing. I even give presentations drafting off this trend (because we have been doing it for a long time and have a much different take on it). This chart below, from Seth Godin via Derek Hernquist, outlines how idea adoption works. As an investor seeking alpha, you want to be towards the left—maybe not all the way (you know the quote about the market’s irrationality and your solvency) but certainly left of center. As Jim Grant always says something like, “successful investing is about having everyone agree with you…later.” Where do you think smart beta is today? I think somewhere between hot and mass. If there was an investing version of this you’d probably want to rename “mass” to “mess.”

smart beta

Smart beta has been around a long time (ask anyone several decades into a relationship with DFA). But it turns out that while you cannot teach an old dog new tricks, you can give an old strategy a spiffy new name with tremendous results (at least in terms of AUM).

Remember what most of these strategies do: they introduce a tilt (usually a small to moderate one) towards smaller cap value stocks and away from larger cap growth ones. Value = low expectations + general pessimism. If everyone buys value a little bit blindly, that may lead to slightly higher overall expectations (i.e. higher p/e or p/b or ev/ebitda ratios) even though those buying these cheap stocks through a “smart” strategy know nothing about those individual stocks.

With all this in mind, the idea adoption chart is a useful tool for those making or recommending investments. Ask yourself, where does a given strategy lie on the continuum? There is nothing more seductive than a strategy with a compelling narrative and a strong recent track record. Buying those kinds of strategies can still be very good for the long term (I think value qualifies here), but just make sure you aren’t constantly rotating your portfolio from one hot dot to the next. If there is any attainable edge/alpha in investing, this is it: find earlier stage stuff and stick with it through its cycle of efficacy (which may last forever, even if it is diminished like many argue value has become).

The best paths for the future aren’t paths yet, they have yet to be blazed. Question your biases and preferences, hunt where others aren’t.