Morningstar Advisor - October/November 2012 - (Page 57)

Arnott: Low volatility has tremendous merit, because the largest anomaly in the finance world is that the capital asset market line empirically is flat to inverted instead of upward-sloping. As so often is the case, the biggest profits in our business are found in areas where finance theory and the real world part company. Finance theory says, returns should be linearly linked to beta, and that line should start at the risk-free rate and move linearly upward to reward more beta with more return. The empirical reality is totally different from that, creating a wonderful investment opportunity. The size effect is simply capturing the value effect through the back door. The value effect itself is—and here I’m going to be controversial—a proxy for price error, also through the back door. There are companies that deserve premium or discounted valuation multiples. Those companies will typically have discounted or premium valuation multiples on average, over time. But you can’t say the reciprocal. Companies that have the higher or the lower valuation multiples don’t always deserve it, and they do tend to self-select, so that there’s more premiumvalued stocks than there should be, creating the value effect. I think the dominant effects at work are pricing error, which is proxied by value. Momentum and—I would give a nod to Cliff—liquidity also enter the picture. What the four-factor model misses is both liquidity and the fact that value is merely proxying for mispricing instead of capturing it in a more direct way. Let me give a concrete example. We have a draft paper, in which we look at a whole array of some of these new popular quasi-indexes— call them strategy indexes—like Fundamental Index, risk-efficient, and so forth. We take these indexes and turn them upside down. We run them completely backwards, turning the algorithm on its head. Instead of getting a negative alpha matching the magnitude of the alpha of the original strategies, we get a positive alpha. It’s often even bigger than the original strategies, which tells us that when people think that their thesis—their basis for developing a strategy or a strategy index—is well founded, all they’re really capturing is factor tilts. When we turn these strategies on their heads, if they still wind up capturing the same factor tilts, they still add value. And if they capture the factor tilts even more intensely because they’re such bizarre strategies, they capture them even bigger. It’s a very fun way to turn the whole notion of strategy indexes upside down, including our own. Asness: I’m looking for a model like that, I think anything illiquid should, in theory, pay an illiquidity premium. It’s harder to do empirical tests here, but I think what evidence exists suggests that it does. I wonder, however, considering the places you typically buy illiquidity—private equity, venture capital, things like that—whether the end customer gets a good enough deal net of the gigantic fees to capture the illiquidity premium. That is a separate question from whether illiquidity is a real factor. I’m somewhat cynical about whether investors can capture it net of costs, but I’m not cynical about whether it exists. When you leave the world of individual stocks and start looking at yield curves and currencies, you get a very distinct strategy called the carry strategy that does get rewarded over time. As many investors will know, occasionally it gets whacked pretty hard. In geek-speak, it’s a negatively skewed strategy. Including those periods, it’s had a very attractive long-term return. You do have to size it at a level that those periods don’t kill you. But we think carry is a pretty pervasive factor around the world. Arnott: Just one closing observation. I’m not because that way, if one day I wake up and accidentally buy what I was supposed to short, I’m completely safe. (laughter) Seriously, Rob and I completely agree on the core set of factors. I might think value is working more for irrational reasons than Rob does, but we absolutely agree that it’s one of, if not the, core factor. I share Rob’s view on size. Momentum, we agree on. Low beta, Rob is right.The empirical capital asset pricing model is a failure over very long periods. I do think Rob tends to dismiss all theory too quickly (laughter). Rob cites his papers, I cite mine, and it’s like a Western duel with tumbleweeds blowing around. So, I’ll cite another one. It’s not mine, but a few people at AQR have written a paper extending the capital asset pricing model to include leverage aversion. People are unwilling to do one of the assumptions of the capital asset pricing model: lever up the market portfolio. It doesn’t prove that it’s the cause of low-beta investing, but it leads directly to a much flatter line and to the low beta effect. Some famous person said that it takes a theory to beat a theory. I’m not dismissive of all theories, but I share Rob’s dismissiveness of the single-factor capital asset pricing model. We can pretty much put that to bed, given a century or so of evidence. as dismissive of theory as Cliff thinks. Asness: Maybe just my theories. Arnott: (laughter) I have tremendous admiration for the advances made in the academic community in deepening our understanding of how markets function and how markets should function. I’m very dismissive of those that think that theory is reality. Theory is an approximation of the real world, and there are some marvelous profit opportunities in the gap between theory, between the way the world ought to work, and empiricism, the way the world does work. K Paul Justice, CFA, is Morningstar’s director of passive fund research. 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Table of Contents for the Digital Edition of Morningstar Advisor - October/November 2012

Morningstar Advisor - October/November 2012
Contents
Contributors
Letter From the Editor
Ill Communication
Do You Use Factor-Investing Strategies?
Practicing What She Preaches
How to Determine the True Price of ETFs
The Quant Factor
Managers Dispute the Death of Equities
Investments á la Carte
Investment Briefs
Five Inconvenient Truths of Manager Research
Health Care’s Outlook Clarifies
Exploring the World of Factors
Uncloaking the Alpha Machine
Factor Strategies Gain Footholds in Practices
Big Mo
Fitting Factors Into the Formula
Clients Have a Friend in Luther King
Less-Liquid Holdings Mean More-Solid Results
Retirement-Withdrawal Strategies Quantified
Amid Turmoil, Don’t Discount Foreign Equities
Our Favorite Mutual Funds
50 Most-Popular Equity ETFs
Undervalued Stocks With Wide Moats
Should I Stay or Should I Go?

Morningstar Advisor - October/November 2012