It’s been a while since my last blog. I wanted to check in, and review some topics that I’ve covered in the past.
So much has changed in the year and a half since I last wrote. For example, there is now an “AI” button in my blog editing window that is offering to write this blog for me.
At the same time, so many things are “same as ever”. For example, everyone continues see “a lot of uncertainty in the markets” and things continue to look foggy ahead and clear in hindsight.
Uncomfortable IS PROFITABLE
Unlike the generally agreed upon yet not very useful concept of “market uncertainty”, the much less appreciated and more useful concept that also stays the same is that markets (stocks, factors etc.) continue to move in the direction that is most uncomfortable to predict, because the comfortable direction is already priced in.
For example:
Last year, it was uncomfortable to predict that inflation will be solved by now.
This year, it was uncomfortable to predict that a full recession will be avoided.
In September, I had the honor of speaking on Meb Faber’s podcast, where we discuss this idea in more detail. I gave an example that predicting a market doubling is much less comfortable than market halfling. What is comfortable is already priced in and so it’s only the uncomfortable views (if correct) that make money. That’s why forecasters are famously always wrong - even when they are correct, their forecasts are already priced in.
What’s the most uncomfortable view can you have today? - that’s the one to watch out for.
Long-Run Evidence alleviates ABANDONMENT RISK
On the podcast, we also discussed my latest academic paper on long-run asset allocation where I use almost a century of data (building on top of other long-run work of the past 10 years) for many asset classes and factors. I run a horse race between the popular asset allocation approaches from 60/40 to Risk Parity, Endowment Based, Factor Based and Dynamic Asset Allocation. At this point, it’s not news to anyone paying attention that Dynamic allocation historically crushed the other approaches on drawdown protection in traditional growth recessions.
However in 2022, things were different. Both stocks and bonds suffered a drawdown during inflation driven correction, so Dynamic approach came down as hard as the other approaches, in the 20-30% range. Yet the absolute drawdown was still much better than the max drawdowns of 60/40, which ranges from 30-70%.
STRATEGY timing REDUCES RETURN
Unfortunately, most investors continue to ignore historical evidence of crashes and dry spells of their chosen approaches. That leads them to sell out of their allocations when either of these two risks shows up.
Poor timing contributes to the difference between dollar-weighted returns (the ones investors actually get to earn) and the time-weighted counterparts. Watching my own clients add and remove assets from their accounts based on recent deviations from trend return confirms this human tendency. Sticking with a negative deviation is uncomfortable and yet was the right choice when the underlying source of return is reliable. Remaining invested in reliable approaches continues to be the most prudent answer - albeit much easier said than done.
FactorS BOUNCED BUT ALPHA decayED
Speaking of staying invested, my 2020 blog on why value investors should not give up was well timed. The bounce back from the extreme drawdown gave factor investors a short-term relief. However, my other point stands that the long-term “alpha” in traditional factor investing is likely gone. Because factors were not some "reliable premia” as the academics would have us believe, but were basic anomalies that generated alpha by identifying types of companies that were uncomfortable to hold. Proliferation of quants and smart beta, made these approaches comfortable and unprofitable. As a quant, this is hard to admit (and i have dedicated a lot of time to showing that these factors were real over the long run and not results of datamining). But ironically, it is the contrast of the flat return of last two decades vs the positive return of the prior two centuries, that is the most alarming evidence of factor’s decay.
For anyone who still doubts that factors can get arbitraged away just watch how the top hedge funds manage their capacity. Most of the top funds are closed to new investors and have been closed for a long time. These funds are giving up tens (if not hundreds) of millions of fees by not accepting the easily available additional demand. Something that traditional asset managers would gladly accept. Why do they forgo these easy profits? Because additional AUM would eat into their ability to generate alpha and hence their long-term profits. So if a hedge fund choses to close at 50billion to avoid the risk of alpha decay (where alpha is made up of hundreds of signals), how can traditional factors take in a couple trillion of AUM into a small handful of factors and still maintain their alpha?
What’s is the main antidote to alpha decay? - innovation.
What’s the main enemy of innovation? - bureaucracy.
ALPHA IN Intangibles
Intangibles are one way to generate innovative alpha as they continue to play a large role in company dynamics. There isn’t a week that goes by, that I don’t see a headline about some company’s culture deterioration causing a crisis or CEO style impacting company culture. These are hard to value assets that are material to the future fundamentals. Just because they are hard to measure, does not mean they are not important. In fact, from the perspective of alpha, this difficulty of measurement makes them even more valuable.
I recently gave a series of talks on intangibles investing at QuantStrats NYC and London, Nuedata, and in this Interactive Brokers webinar that you can watch for free. The webinar is filled with examples of how intangibles can be measured in innovative ways, using language. In one example, I show how we can trace Steve Job’s language in the Apple’s 10Ks. It points to the creative direction in which he took the company when he returned as the CEO in 1998.
Although intangibles investing has proven to be a huge source of alpha over the past two decades, this approach did experience underperformance in 2022. The rise in long-term interest rates affected companies with longer duration assets, which intangibles by definition are.