Tuesday, 3 March 2015

Size doesn't matter (in investing)

Small-cap stocks no better than large caps - It is a waste of time to add a separate small-cap ETF or "tilt" to a portfolio since the extra return from small cap stocks can no longer be observed in the USA where it was first named, nor in any other market around the world, as Vitali Kalesnik and Noah Beck write in Busting the Myth about Size.

Worth a tilt - The tried- and still-true sources of equity premiums are market (the basic one that we get when we buy a total market ETF), value, momentum and low volatility, which Jason Hsu and Vitali Kalesnik conclude in Finding Smart Beta in the Factor Zoo. One interesting note they make is that while value and low volatility are amenable to low cost, transparent, rules-based, low turnover investing (such as in ETFs), capturing the momentum factor is best done through active alpha managers.

Avoiding back-tested data mining - There is also a sensible-looking list of criteria for deciding whether some return-enhancing rule discovered in past data is actually an equity premium source / risk factor or just a data mining artifact that will almost surely not work in future:
1.    The factor was discovered many decades ago; it has survived numerous database revisions as well as extensive out-of-sample data.
2.    The factor has been vetted, replicated, and debated in top academic journals over decades.
3.    The factor works in non-U.S. countries and regions.
4.    The factor premium does not change materially due to minor variations in the factor definition/construction.
5.    The factor has a credible reason to offer a persistent premium
a.    It is related to a macro risk exposure, or
b.    It is related to a deep-rooted behavioral bias that is present in a meaningful fraction of investors, or
c.    It is related to an institutional feature that cannot be easily changed.
6.     The factor exceeds a more stringent t-stat threshold of 3.5 (preferably 4.0) instead of 2.0 to adjust for data-snooping and other biases evidenced by the recent explosion in factor proliferation."


Patrick said...

In your opinion, does Fundamental Indecing meet these criteria? I suspect not.

What about Dividend Investing?


CanadianInvestor said...

Hi Patrick, At the moment I believe that RAFi's version of fundamental indexing amounts to a more efficient way of exploiting the value premium.

Dividend investing I view as active investing. Though there is a fair amount of research from the investment industry that focusing on dividend stocks (as opposed to non-div payers) has worked well (e.g. on Tweedy Browne website), there is not so much from academia. High div stocks seem to decompose into a combination of low vol and value factors.

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