It’s Better With Beta

81IkSz1gpjL._SL1500_The title of Larry Swedroe’s latest book, The Incredible Shrinking Alpha, raises a question: what happened to the idea that skilled managers can consistently beat the market? In a recent interview with Swedroe, we discussed the idea that this ability hasn’t really disappeared: it’s just that “alpha has become beta.”

What exactly does that mean? In investing jargon, alpha is the name given to the excess return a fund manager achieves through skill. Beta, on the other hand, refers to the returns available to anyone who is willing to accept a known risk. When Swedroe says “alpha has become beta,” he simply means that anyone who understands how to structure a portfolio can increase their expected returns by simply changing their exposure to specific types of risk, known as “factors.”

A factor is a characteristic of a stock that affects its expected return and risk. Factor investing (sometimes marketed as “smart beta”) means identifying which of these characteristics might predict higher returns in the future—even if it also brings more risk—and then building a diversified portfolio that captures those returns in a systematic way, without resorting to picking individual stocks.

And then there were three

As I’ve written about before, the so-called Fama-French Three Factor Model was a revolution in investing. In a landmark 1993 paper, Eugene Fama and Kenneth French argued that the vast majority of a stock portfolio’s returns could be explained not by the manager’s genius, but by its exposure to beta (market risk), small-cap stocks (which are expected to outperform large caps over time) and value stocks (companies with low prices relative to fundamentals such as book value, dividends and earnings, which tend to outperform growth stocks).

But it didn’t end there. Later in the 1990s, a fourth factor was identified: momentum, or the tendency for stocks that have recently performed well (or poorly) to continue in the same direction. In the last few years, researchers have identified several more. First was the profitability factor: companies with a high ratio of gross profits to assets tend to outperform, even though these are generally growth stocks, not value stocks. That was followed by the investment factor, which is based on the counterintuitive idea that capital expenditures on new acquisitions and ventures usually fail, and therefore lead to lower stock returns in the future.

The factor zoo

If you this all sounds overly complicated, you’re not alone in that opinion. One finance professor famously described the “zoo of new factors” now in the academic literature. “Something like 300 factors have been identified,” Swedroe says. “Because there is a big premium on being published, you want to be the professor who finds a factor: then you can go and get a job on Wall Street.” One commentator reported that “some quant shops now use an 81-factor model to build equity portfolios.”

The good news, says Swedroe, is that no one needs anything close to an 81-factor portfolio. “The thing to understand is that some of these factors are really just manifestations of some other factor,” Swedroe says. In a new paper, Fama and French acknowledge that once you consider beta, size, value, profitability and investment, none of the other factors have any meaningful explanatory power. (This idea is discussed in the final appendix to The Incredible Shrinking Alpha.)

Five is enough

In our interview, Swedroe used an analogy to explain why simple portfolios get you most of the way there.

“Say you’re taking a drive across Canada, and it’s 3,000 miles. And let’s say that during each leg of your journey you drive halfway. So the first leg you drive 1,500 miles, and the next leg you drive 750 miles, and so on.” You make progress every day, but each successive leg of the journey has less of an impact. “It’s the same thing with a portfolio: if you add bonds to a stock portfolio, that’s a big move. Then you add international stocks, and that’s a pretty big move too, though not as big as adding bonds. Then you start adding small-cap and value. Once you’re at that eighth or ninth asset class, yes, you will pick up something, but you’re already most of the way there. So we want to focus on the factors that really matter the most: the ones with the big premiums, as well as the ones that help diversify. And I think the literature is pretty clear now that we’ve got these five.”

Swedroe also points out that more factors may mean fewer stocks. “If you keep adding screens, what happens is you get a less and less diversified portfolio. You could start out with a small-cap portfolio that is 2,500 stocks, and then you make it small-value and you’re down to 1,500. Add another screen and you’re down to 700. At some point you don’t have enough of a diversified portfolio. So you have to make decisions about how to do this.”

One decision might just be to stick to a plain-vanilla Couch Potato strategy. In fact, if you’re a DIY investor you probably should. Factor investing may be able to increase your returns slightly over the long term, but only if you have the expertise to manage a more complicated portfolio. Consider it the icing, not the cake itself.

 

17 Responses to It’s Better With Beta

  1. Andrew Macdonell August 15, 2015 at 8:30 am #

    Dan – you should be writing curriculum. Thank you for this blog.

  2. Maxwell C. August 16, 2015 at 4:22 am #

    Well-said!

    Dan, I would also love to see you write articles (perhaps put this under “Ask the Spud”) on two things:

    1. Your response to the “hot potato portfolio” that was proposed. I would like to see what you think of it.

    2. And more importantly… yet another article revisiting ETFs vs. Mutual Funds, now that Questrade is offering free purchases of *any* listed ETFs, as the argument of “but their offerings so far as commission-free ETFs go are limited mostly to sector-funds and the like” seems not to hold water any more.

    Watching and waiting 😛

    Still enjoying your blog, which is amazing considering how long I have been following it, and how long it has remained both interesting and well-written. Keep up the excellent work! I recommend this to people ALL the time! 🙂

    These should be easy articles…get to writing? 😛

  3. Maxwell C. August 16, 2015 at 4:36 am #

    Basically…http://canadiancouchpotato.com/2012/06/28/an-overview-of-commission-free-etfs/ needs an update.

  4. Canadian Couch Potato August 16, 2015 at 9:54 am #

    @Max: Thnaks for the comment.

    RE: the Hot Potato Portfolio, this is just one of several thousand hypothetical strategies that would have beat a traditional index approach if it was executed perfectly. The real question for me has always been why no one has ever been able to demonstrate that they actually used one of these strategies to achieve actual real-world results:
    http://canadiancouchpotato.com/2012/05/25/why-isnt-everyone-beating-the-market/

    Regarding, commission-free ETFs, I get this question a lot, so maybe it is time to write about it again. I’ve touched on it in the past:
    http://canadiancouchpotato.com/2013/02/19/why-index-mutual-funds-still-have-a-place/

  5. Steve August 16, 2015 at 5:35 pm #

    Can we get this book published in the Google play store? Tried to buy it for my phone, but it wasn’t available…

  6. CharlieF August 16, 2015 at 8:37 pm #

    RE: MF vs ETF.
    IMO, its simply the hassle of rebalancing calculations, advantages of partial shares, ease of automatic savings that would have me use MF over ETFs….depending if the extra ~70basis points is worth it.

    ~~

    Beta is volatility right? So if I purchase a low-beta (low-volatility) ETF, wont I beat the index then?

  7. Canadian Couch Potato August 16, 2015 at 9:23 pm #

    @Steve: There is a Kindle edition, but looks like there’s no Android version.

    @CharlieF: Low-beta stocks definitely do not guarantee underperformance:
    http://canadiancouchpotato.com/2012/11/26/the-promise-of-low-volatility/
    http://canadiancouchpotato.com/2012/11/29/inside-the-bmo-and-powershares-low-vol-etfs/

  8. Maxwell C. August 17, 2015 at 12:15 am #

    @Dan…any time 🙂

    Good point on the Hot Potato (re-reading that article now…it’s been a while, thank you for the link). Perhaps these magical, entirely theoretical strategies will become practical realities eventually, once robo-advisors are more “advanced”, cheap (was looking at them…damn do they ever charge a lot), and commonplace. Then again, perhaps not.

    I would love to see an updated post regarding the commission-free options, as now that my portfolio is of sufficient size, I am looking to move out of the e-series and into ETFs, while still making regular contributions.

  9. Doug August 17, 2015 at 8:31 pm #

    Steve, I went to amazon prime and downloaded Swedroe’s book. I got two free ebooks when signing up. I plan to cancel before the monthly subscription fees kick in. Yes, I’m very cheap.

    Dan, I know that you’ve covered rising rates and it’s affects on short and long-term bonds fairly extensively. I’ve gone back and read your multiple posts. Since those posts, anyone switching to short bonds has gotten the stinky end of the stick. Yes, it’s always “different this time” but with The Fed literally spelling it out, is it? Is my logic too simple in thinking that there are far more rates higher than the number zero? In other words, isn’t it more likely that rates will rise? And if they fall(or stay put), they can’t fall by much, can they?

    With the announcement coming soon, do you think you could do another post on the difference between short and long bonds. Even beyond 3 years, as The Fed suggests will happen? Maybe even explain the affects of a half short, half long term fixed income portion. Is that counter intuitive?

    I noticed that J. Bender has one model portfolio with all short term and another example with only long term. Nothing with a blend of the two. Maybe it’s just to keep things simple? Can I ask what kind of bonds you hold in your personal”forever/retirement portfolio”?

    Thanks either way, Dan,

    Doug, the question guru

  10. Canadian Couch Potato August 17, 2015 at 9:18 pm #

    @Doug: I’m not sure what’s left to say about bonds. If rates rise, you will be better off (at least initially) with short-term bonds. If rates fall or stay the same, bonds with longer maturities will outperform. No one has any idea when rates will rise, nor by how much, regardless of how supremely confident they may be. Once you accept you cannot forecast interest rates, the sensible strategy is to choose a duration that fits with your long-term goals and your risk tolerance.

    In my case, I hold a broad-based bond ETF, as I have no plans to touch my RRSP for 20+ years and I’m not concerned about short-term volatility. Someone in retirement or very risk-averse may choose to use short-term bonds instead, and that’s perfectly appropriate. That’s why Justin includes both options in his model portfolios.

    One clarification: broad-market bond funds like VAB, XBB and ZAG do not hold “only long term bonds.” On the contrary, they are about 40% to 45% short-term bonds (under 5 years), with another 25% in intermediate bonds (5-10 years). Only a relatively small amount is in long term bonds.

    In any case, combining a broad market fund and a short-term fund is reasonable enough: by doing this you can lower your duration to wherever you want. For example, equal amounts of a broad-based fund (duration 7) and short-term fund (duration 3) would give you a bond portfolio with a duration of 5. I’m just not sure it’s necessary to get that precise.

    Another thing to consider is a GIC ladder instead of a bond fund. They provide an ideal way to spread out interest rate risk: that is, they don’t get hit too hard whether rates go up or down.

  11. Doug August 18, 2015 at 12:14 am #

    Perfect explanation!

    I think I’m going to stick it out with VAB. Now that that’s cleared up, I can go back to mindless, robotic investing and attempt to break free of my financial current events addiction.

    Thanks again, Dan

  12. Willy August 18, 2015 at 8:07 am #

    Another point on the bonds that is often missed by many people – the Fed (or Bank of Canada) does not control movements in long-term bond rates by moving their overnight interest rate. Most of the anxiety around bonds seems to be related to long bonds and the potential for losses when rates rise, but this is far from certain to happen when the Fed starts moving an overnight rate. The movement of long bonds is quite decoupled from the Fed overnight rate. Just another reason why you should make no attempt to forecast this and just stick to your plan.

  13. Jake August 21, 2015 at 4:22 pm #

    I would bet that we won’t see a decline of a broad based bond index fund in the next 10 years that we have seen in the global equities the past week.
    I try to use common sense. To hear how well the USA economy is doing but yet have the market drop like it has this past week and especially today and the Fed scared to increase rates doesn’t seem to me like the economy is diong so hot.
    China may bs slowing however it’s still doing a lot better than north america has in past few years. I think we should look after ourselves first and worry about others later.
    Trump in white house is badly needed, he couldn’t do any worst !!!

  14. cmj August 21, 2015 at 4:49 pm #

    Thanks, Dan, for bringing Swedroe’s valuable information on investing to your blog. I was able to get his previous book “Think, Act, and Invest Like Warren Buffett: The winning strategy to help you achieve your financial and life goals”. This book is packed with common sense and supported by research. I especially appreciated his detailed outline of how to balance a portfolio. This book is an easy read and reinforces how not to get caught up in the noise. Lately, the markets are churning and it does affect the stomach. It was a timely read and his key points help any investor to sleep at nights and reduce the urge to press the panic button.

    I have been reading your blog for a long time and have valued your insights and educational resources.

  15. Jake August 22, 2015 at 10:21 am #

    @cpp

    Is this a time to rebalance with such a large loss of equity value or should we just leave alone and save the trading costs till enf of year when for example I usually rebalance ??

  16. Canadian Couch Potato August 22, 2015 at 10:55 am #

    @Jake: As always, it depends on the details. Is your portfolio way out of balance or just a couple of percentage points off its targets? Would selling something realize taxable gains? How much are you paying in commissions relative to the size of the trade? Are you planning to add new money to the portfolio in the next little while? Rebalancing frequency is always a trade-off.

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