A Walk in the Woods: Evaluating Investment Strategies for the Long Haul

A Walk in the Woods, the book by Bill Bryson and movie starring Robert Redford and Nick Nolte, is a humorous yet also insightful account of two novice hikers who set out to through-hike the Appalachian Trail. The endeavor parallels that facing many investors: setting out on what seems an almost implausibly long adventure with very little first hand knowledge of the challenges they are likely to encounter along the way.

The parallels between hiking and investing extend further. In both cases, the participants receive all kinds of advice and are sold all sorts of things that turn out being either of dubious value or entirely counterproductive. Two guidelines stand out that apply as much to investing as to hiking. One is that fees are like gear in your pack - too much stuff that isn't very useful can really slow you down, but some of that gear is really useful. Another is that the environment changes over time - which implies that different gear is appropriate at different times.

Investment strategy is an extremely important decision for investors. The three main approaches of active, passive, and smart beta (also known as factor investing) each has advantages and a deserved role for certain situations. Too often, however, the pros and cons of each are overly simplified and applied dogmatically with little consideration given to how conditions might change over time.

While active management as a whole has performed poorly, that poor performance has not been universal as many assume. Research over the last several years reveals that the underperformance is not so much a structural issue with active investing as it is an endemic problem with the industry. It shouldn't be surprising that active portfolios that are fairly concentrated, that charge reasonable fees, and that focus on inefficiently priced asset classes tend to perform better. In other words, active management is far from a futile exercise, but it does depend on the judicious use of "gear".

Critics who are completely dismissive of active management miss the reality that there are a number of excellent managers. Indeed, it defies common sense that given examples of exceptionalism in every realm of human endeavor, that there would be none in the field of active management. It is right to be skeptical, but not to be dismissive.

A big part of the challenge for active investing is the cost/benefit tradeoff of its fees and this is exactly why passive investing has been such an attractive alternative. Indeed, passive investing today provides a far better way for people to gain exposure to the market than the main option available thirty years ago of buying a couple of individual stocks. No doubt, passive investing has been a useful addition to the amalgam of investment offerings.

That said, the lower fees of passive investing relative to active do not provide an apples to apples comparison and are understated in an important sense. More specifically, Research Affiliates [here] notes that, "Collectively, an active manager’s very important role is to increase market efficiency by identifying mispricing." In doing so, active management actually provides a socially useful service in the form of price discovery by effectively making sure that market prices are fairly accurate. Without the efforts of active investors, there would be no natural forces to prevent prices deviating wildly from intrinsic values.

As things currently stand, the costs of the service of price discovery accrue solely to active management clients, but the benefits accrue to passive management clients. Kenneth French (2008) [here] studied these costs and found, "From society's perspective, the average annual cost of price discovery is .67% of the total value of domestic equity." This non-trivial cost accounts for a big chunk of the difference between active and passive fees. Indeed, it's been a great deal for passive investors: it has been like having your hiking companion carry the tent, all of the food, and any shared gear for both of you, with no reciprocity.

In addition to the traditional approaches of active and passive investing, a "third way" approach, often referred to as smart beta (factor investing), has become increasingly popular. The smart beta approach attempts to capture the best of both the active and passive approaches by facilitating low costs through automated selection processes and excess returns by leveraging finance theory and research. One well known "factor", for example is "value" and a recent favorite is "high quality" (usually determined by gross profitability). Smart beta is a legitimate concept and there is good reason to expect future developments in this area.

Two threads of theory are relevant here. One was developed over twenty years ago by Kenneth French and Eugene Fama. Their research showed that returns could largely be described by the three factors of beta, size, and value in what is commonly referred to as the "three factor model" [here]. The implication for investors is that higher returns can be realized by increasing exposure to smaller stocks and to cheaper stocks. The economics of this quantitative approach have improved substantially as the costs of commissions and computing power have fallen relative to the costs active managers incur for doing fundamental research.

Another thread of research pioneered by Research Affiliates argues that many indexes can be improved by weighting their constituents by variables other than that of market capitalization [here]. Cap weighted indexes (such as the S&P 500), the argument goes, overweight the most overpriced stocks and underweight the most underpriced stocks, and therefore make systematic valuation errors. Their research shows that simply making random errors, as opposed to systematic ones, improves performance by about 2% per year.

While this body of research certainly provides a valid foundation for some kind of smart beta (factor investing) approach, the investment industry has outdone itself the last few years by unveiling an enormous array of factor investing approaches to an investment audience ravenous for low fees and better performance. The recent paper put out by Research Affiliates entitled "How can 'smart beta' go horribly wrong?" [here] provides some excellent research to help evaluate the recent proliferation of factors.

Perhaps the single most important message from the paper is that the impressive results attributed to many of the new factors reveals more about the industry's willingness and ability to mine data than it does about important new factors. More specifically, the authors found that, "factor returns, net of changes in valuation levels, are much lower than recent performance suggests." In the case of high-profit companies, for example, they found, "When we subtract the returns associated with the rising popularity, and therefore rising relative valuation ... the gross profitability factor loses more than 90% of its historical efficacy, delivering 10-year performance net of valuation change of just 0.39%." In other words, "Many of the most popular new factors and strategies have succeeded solely because they have become more and more expensive."

While evaluating the costs and benefits of the three main investment strategies is a formidable task in its own right, investors in it for the long haul shouldn't stop there. As the factor evidence highlights, things change over time and this is absolutely holds true for the relative merits of investment strategies. John Authers highlights this point well in theFinancial Times [here]: "Using data from the past 25 years, Mr. Jones found a strong positive correlation between recent performance and buying decisions, in equities and bonds, for all of the classes of asset owners he looked at." In other words, at the group level, everyone is a trend follower! In an important sense, this insight is frightening, but it also provides a useful warning: investment strategies may be just as subject to "inefficient pricing" as their underlying assets.

It's worth considering how such inefficiencies might get resolved. In the case of passive strategies, investors have been enjoying the benefits of efficient price discovery without having to pay for it. Insofar as the free ride persists, there is every reason to believe that investors will continue to jump on the passive bandwagon. The consequence of such trends will be to erode, over time, the ability of active investors to keep market prices fairly efficient. As this continues to happen, it is fair to expect that pricing efficiency will decline to a point where sufficient opportunities emerge for a smaller group of active investors to earn attractive returns over their costs, and that such excess returns will come at the expense of passive investors. In short, the free ride for passive investors may well be a one time gig.

Smart beta too has had a very good run over the last few years but much of that appears to be temporal as well. As Research Affiliates notes, "We find that the efficacy of a factor-based strategy or a factor tilt (included by many under the smart beta umbrella) is strongly linked to changes in relative valuation, that is, whether the strategy is in vogue (becoming more richly priced) or out of favor (becoming cheaper)." Thus, since "Value-add can be structural, and thus reliably repeatable, or situational—a product of rising valuations—likely neither sustainable nor repeatable," for many recent factors, the evidence points to situational and unsustainable. As a result, the authors conclude that "it's reasonably likely a smart beta crash will be a consequence of the soaring popularity of factor-tilt strategies."

The Research Affiliates authors don't uniformly disparage factors, however. Rather, they recognize that, "For the past eight years, value investing has been a disaster with the Russell 1000 Value Index underperforming the S&P 500 by 1.6% a year, and the Fama-French value factor in large-cap stocks returning -4.8% annually over the same period." Largely as a result of that poor past performance, they find that the old French-Fama factor of value is currently "in it's cheapest decile in history," and therefore an attractive factor.

Finally, the prospects for active management are mixed. On one hand, there are far too many active managers and far too many that charge fees greater than the benefits received. As a result, it is reasonable to expect the numbers to shrink. It is distinctly possible, and perhaps even likely, that as the active herd get culled, so too will ever increasing opportunities emerge for efficient and focused active managers that aren't "carrying too much weight" to take advantage of the overshoot of passive and smart beta strategies.

A general lesson, from all of this, is that since the relative attractiveness of different investment strategies changes over time, it doesn't make sense to take a dogmatic view towards them. Combined with the reality that each strategy has its own particular strengths in certain situations, it also makes little sense to think of any one strategy as being mutually exclusive of the others. The bottom line is that it makes the most sense to remain flexible.

Further, there are two more specific lessons to consider in selecting investment strategies. One is to make sure that you get a good return from the fees that you pay, i.e. that you get a good "bang for the buck". The other is that it makes sense to monitor changes in the environment that may warrant a different approach. Some of what passes as an "advantage" to one investment strategy in one situation may very well end up being a transient factor that can hurt you in the future. Your journey will be easier if you have the right "gear" ( in the form of the right investment strategy ) for each environment.

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