(Not so) Smart Beta

tech/a · 11 December 2014

Well from what I see the risk of being in an illiquid number of trades where there could be very large slippage if I needed to liquidate and the risk of delisting not normally attributed to the more liquid stocks----seems to be larger than the added reward over time.
I'd also suggest that any outlier shock in the market would see the illiquid stocks take longer torecover if indeed they did at all.

DeepState · 11 December 2014

tech/a said:
Well from what I see the risk of being in an illiquid number of trades where there could be very large slippage if I needed to liquidate and the risk of delisting not normally attributed to the more liquid stocks----seems to be larger than the added reward over time.
I'd also suggest that any outlier shock in the market would see the illiquid stocks take longer torecover if indeed they did at all.

The sorts of risks outlined above are why people shy away from those situations and why the return from them exists. It is a rewarded risk. It's up to you as to whether the reward is sufficient for the risk borne. Reward for risk bearing has been reported. As much as anything, the reward arises because people think in terms of scenarios as above without necessarily considering actual attaching probabilities accurately or otherwise developing these from small samples, hold concentrated portfolios where liquidity risk is more material for adverse developments, consider that they have strong alternative uses for capital and have short time horizons. There is nothing wrong with that per se. It is what you have described.

For those that can invest in a broader portfolio of stocks that allows diverse exposure to the concept where good and bad breaks happen and wash out over time and/or accept the fact that rewards to this concept reveal themselves unevenly but with higher confidence through time and can hack the journey....the concept is more appealing.

What's the reward? What's it worth....to you? Maybe it's not worth it for you. That's fine.

One possible way of thinking about this, which I think has validity, is that liquidity is relative. A small portfolio whose holdings match that of another monster portfolio do not require the same degree of premium for bearing illiquidity risk. The price for risk differs. There is a price for this and it would imply that smaller portfolios should hold relatively less liquid stocks on average....all else equal. They are in a better position to take this risk than large portfolios. As I said before, the market is a risk transfer mechanism. The premium exists with high certainty. As with investments generally, it's a question of what that actually means for you.

DeepState · 11 December 2014

TPI said:
In broad terms for me this means things like:

Low volatility stocks (which usually leads me to an overall large and mid-cap tilt)

luutzu · 11 December 2014

DeepState said:
View attachment 60680

Doesn't that article just state the obvious?

That if a fund is low-volatility... first, it is defined low on price volatility because it does not "volatate" (my word) far from the market/index; that a high volatile fund/stock would move up or down more "volatile-ly" than a low one.... So of course a low-volatile fund would do well during highly volatile periods.

Sorry to interrupt.

Can I ask a serious question?

Do you guys, or institutional investors and professionals... do you guys look at beta and alpha and macro data, market/industry forecasts and the like... do you guys look at these because you have already looked at the annual reports, already know the company very well and this macro analysis is to give you that extra edge?

Or do you only have some familiarity with the individual business but think that that's not where your focus should be; your focus ought to be with things beyond the company... for that's where the edge is?

In other words, do you already know the business to a great extend (almost to the level of its executives), but that is not enough? Or do you reckon a top down approach is the way to go because statistically, through probability... if the macro is right, the rest doesn't really matter.

Might be a joke of a question but you know what they say, no such thing as s dumb question.

DeepState · 11 December 2014

luutzu said:
Doesn't that article just state the obvious?

That if a fund is low-volatility... first, it is defined low on price volatility because it does not "volatate" (my word) far from the market/index; that a high volatile fund/stock would move up or down more "volatile-ly" than a low one.... So of course a low-volatile fund would do well during highly volatile periods.

You are mashing absolute volatility with tracking error without realizing they are different or knowledge of how total volatility relates to tracking error.

luutzu said:
Sorry to interrupt.

Can I ask a serious question?

Do you guys, or institutional investors and professionals... do you guys look at beta and alpha and macro data, market/industry forecasts and the like... do you guys look at these because you have already looked at the annual reports, already know the company very well and this macro analysis is to give you that extra edge?

Or do you only have some familiarity with the individual business but think that that's not where your focus should be; your focus ought to be with things beyond the company... for that's where the edge is?

In other words, do you already know the business to a great extend (almost to the level of its executives), but that is not enough? Or do you reckon a top down approach is the way to go because statistically, through probability... if the macro is right, the rest doesn't really matter.

Different strokes for different folks.

luutzu said:
Might be a joke of a question but you know what they say, no such thing as s dumb question.

How does that Yin and Yang thing go again?

TPI · 11 December 2014

DeepState said:
Here's some US data:

View attachment 60670

The liquidity premium exists across all size bands. That means that you do not have to tilt to small caps to get the effect. You can, but you do not have to.

Interesting to see the small cap premium in the data. Interesting also that the relationship does not exist for the most liquid quartile and is monotonically in the opposing direction.

Much of this smart beta stuff is actually finding rewarded risk premia. It's not that the returns are there for nothing. It's just that you may be in a better position to absorb these risks than others in the market and hence get the rewards that come with it. Ultimately, the secondary market is a risk transfer mechanism.

Seriously impressed by the thought you have put into this BTW.

Thanks RY, to clarify, from this chart do you infer that small cap with low liquidity gives you the best outcome?

I might read that paper in more detail over the weekend.

DeepState · 12 December 2014

TPI said:
Thanks RY, to clarify, from this chart do you infer that small cap with low liquidity gives you the best outcome?

I might read that paper in more detail over the weekend.

Yes. It has given the best outcome in terms of return.

TPI · 12 December 2014

DeepState said:
View attachment 60680

I think low-vol is a relatively boring concept so concerns that this space is getting overcrowded maybe overdone.

I think human nature will bias us towards more exciting tilts to let this unexciting one persist for longer.

luutzu · 12 December 2014

DeepState said:
You are mashing absolute volatility with tracking error without realizing they are different or knowledge of how total volatility relates to tracking error.

Different strokes for different folks.

How does that Yin and Yang thing go again?

Anyway... back to seeking wisdom... from the Tao Te Ching.

The supreme good is like water,
which nourishes all things without trying to.
It is content with the low places that people disdain.
Thus it is like the Tao.

In dwelling, live close to the ground.
In thinking, keep to the simple.
In conflict, be fair and generous.
In governing, don’t try to control.
In work, do what you enjoy.
In family life, be completely present.

TPI · 12 December 2014

DeepState said:
The sorts of risks outlined above are why people shy away from those situations and why the return from them exists. It is a rewarded risk. It's up to you as to whether the reward is sufficient for the risk borne. Reward for risk bearing has been reported. As much as anything, the reward arises because people think in terms of scenarios as above without necessarily considering actual attaching probabilities accurately or otherwise developing these from small samples, hold concentrated portfolios where liquidity risk is more material for adverse developments, consider that they have strong alternative uses for capital and have short time horizons. There is nothing wrong with that per se. It is what you have described.

For those that can invest in a broader portfolio of stocks that allows diverse exposure to the concept where good and bad breaks happen and wash out over time and/or accept the fact that rewards to this concept reveal themselves unevenly but with higher confidence through time and can hack the journey....the concept is more appealing.

What's the reward? What's it worth....to you? Maybe it's not worth it for you. That's fine.

One possible way of thinking about this, which I think has validity, is that liquidity is relative. A small portfolio whose holdings match that of another monster portfolio do not require the same degree of premium for bearing illiquidity risk. The price for risk differs. There is a price for this and it would imply that smaller portfolios should hold relatively less liquid stocks on average....all else equal. They are in a better position to take this risk than large portfolios. As I said before, the market is a risk transfer mechanism. The premium exists with high certainty. As with investments generally, it's a question of what that actually means for you.

RY, in broad terms what are the things that you consider to be smart beta and dumb beta, and which do you incorporate into your own portfolio construction?

And also, which of these if any do you giver greater weighting/significance too?

With regards to the liquidity premium, from my interpretation of it now and looking at my own portfolios, I find that my larger family trust portfolio (which is about 5 x the value of my SMSF portfolio) has relatively little exposure to this (partly due to it being leveraged), whereas my much smaller SMSF portfolio has a lot more exposure to this... which seems to fit with what you are saying here I think.

TPI · 12 December 2014

DeepState said:
Yes. It has given the best outcome in terms of return.

I guess that's the main thing isn't it?

Would this be different for risk-adjusted return and where a low-vol approach does better?

DeepState · 12 December 2014

TPI said:
I guess that's the main thing isn't it?

Would this be different for risk-adjusted return and where a low-vol approach does better?

There is a Yank saying that "you can't eat risk". So that's possibly right. Given you are prepared to utilize leverage though, it might be better to consider risk adjusted returns, find the most suitable idea based on that and lever up to get the risk you want. That's the way to the best outcome ultimately....if you can get it right. That particular segment might not produce the best risk-adjusted returns.

There are some instos out there who lever the low-vol process back to general equity market levels for example. Leverage is used in risk-parity portfolios for similar reasons.

DeepState · 12 December 2014

TPI said:
RY, in broad terms what are the things that you consider to be smart beta and dumb beta, and which do you incorporate into your own portfolio construction?

And also, which of these if any do you giver greater weighting/significance too?

With regards to the liquidity premium, from my interpretation of it now and looking at my own portfolios, I find that my larger family trust portfolio (which is about 5 x the value of my SMSF portfolio) has relatively little exposure to this (partly due to it being leveraged), whereas my much smaller SMSF portfolio has a lot more exposure to this... which seems to fit with what you are saying here I think.

At present, I use diversification-based approaches to generate additional stuff. It's essentially rebalancing on heat. It is a mathematical property that requires no explanation from behavioural or market micro-structure sources. You can check its existence from the fact that prices move at all. So the source of edge is pretty clear and visible.

Smart beta is a bulk exposure to a concept that you can readily replicate without knowledge of specific circumstance. That concept must expectationally yield a superior outcome. The six bulk betas in the smart beta space for equities are Small Cap, Size, Low Vol, Momentum, Liquidity, Value.

Dumb beta is anything without a very strong a testable hypothesis for believing in a positive expected outcome. Sometimes smart beta is renamed dumb beta "Gee that was dumb".

It is also worthwhile checking to see if the premia still exist. Ex post realization can lead you astray. Strong and sustained excess returns from value can indicate that the forward looking premium has been eroded. Similarly, are low-vol stocks getting super expensive?

I am looking at smart betas in currency right now. I like these because they exist for reasons that can seen. The drivers are large scale and can be confirmed via hard data.

Although these equity bulk betas are useful in an expectations sense, they also segment the market in terms of dynamics. In other words, combinations of these ideas result in habitats where stocks have vastly different characteristics. It's like having different industries. This can be important to people like pair traders....

Smart beta is a marketing label which runs the chance of encouraging investors to believe that investing in accordance with it makes you smart automatically. Including momentum, all of these smart betas are rewards for risk bearing. You get paid because you are the insurer and charge a premium for the service. It is smart to ask what the size of that premium actually is from time to time and whether that risk is worth it.

TPI · 12 December 2014

DeepState said:
There is a Yank saying that "you can't eat risk". So that's possibly right. Given you are prepared to utilize leverage though, it might be better to consider risk adjusted returns, find the most suitable idea based on that and lever up to get the risk you want. That's the way to the best outcome ultimately....if you can get it right. That particular segment might not produce the best risk-adjusted returns.

There are some instos out there who lever the low-vol process back to general equity market levels for example. Leverage is used in risk-parity portfolios for similar reasons.

Thanks RY, my family trust portfolio is predominantly low-vol with only a little bit of small cap exposure and a general value overlay, plus with conservative leverage.

The use of leverage, particularly margin lending, tends to push the portfolio towards low-vol stocks.

DeepState · 12 December 2014

TPI said:
Thanks RY, my family trust portfolio is predominantly low-vol with only a little bit of small cap exposure and a general value overlay, plus with conservative leverage.

The use of leverage, particularly margin lending, tends to push the portfolio towards low-vol stocks.

Nice work, TPI. Your investment portfolio is in secure hands....

If 'conservative leverage' refers to a screen on company selection, then you are also picking up another bulk beta which I did not name. That's the quality phenomenon. If interested, Novy-Marx, Sloan & Richardson and Piotroski are worth checking out. They are not in RAFI processes. Novy-Marx is with DFA along with a lot of other clever people who combine theory and evidence-based practice. You'd be at home there.

TPI · 12 December 2014

DeepState said:
It is also worthwhile checking to see if the premia still exist. Ex post realization can lead you astray. Strong and sustained excess returns from value can indicate that the forward looking premium has been eroded. Similarly, are low-vol stocks getting super expensive?

...

It is smart to ask what the size of that premium actually is from time to time and whether that risk is worth it.

Fair enough, worth checking and being aware of.

DeepState said:
Although these equity bulk betas are useful in an expectations sense, they also segment the market in terms of dynamics. In other words, combinations of these ideas result in habitats where stocks have vastly different characteristics.

That's interesting, maybe best not to get too fancy with the combinations then!

TPI · 12 December 2014

DeepState said:
Nice work, TPI. Your investment portfolio is in secure hands....

If 'conservative leverage' refers to a screen on company selection, then you are also picking up another bulk beta which I did not name. That's the quality phenomenon. If interested, Novy-Marx, Sloan & Richardson and Piotroski are worth checking out. They are not in RAFI processes. Novy-Marx is with DFA along with a lot of other clever people who combine theory and evidence-based practice. You'd be at home there.

Yeah conservative leverage is also part of the stock selection screen.

I have not heard of Novy-Marx, Sloan & Richardson and Piotroski, but thanks I will look them up and read further.

TPI · 12 December 2014

luutzu said:
Do you guys, or institutional investors and professionals... do you guys look at beta and alpha and macro data, market/industry forecasts and the like... do you guys look at these because you have already looked at the annual reports, already know the company very well and this macro analysis is to give you that extra edge?

Or do you only have some familiarity with the individual business but think that that's not where your focus should be; your focus ought to be with things beyond the company... for that's where the edge is?

In other words, do you already know the business to a great extend (almost to the level of its executives), but that is not enough? Or do you reckon a top down approach is the way to go because statistically, through probability... if the macro is right, the rest doesn't really matter.

luutzu, I'm not sure about others, but I just consider these as two separate areas, one being portfolio construction and another being stock selection.

They are not mutually exclusive and both have their place, and I don't think you need to achieve absolute mastery in both areas.

You are right that at the end of the day knowing the business and stock selection is the important and harder part, but as you buy a handful of stocks you are creating a portfolio, and having some extra ideas and concepts to help you build that overall portfolio into something cohesive and sensible to me seems useful.

You are already doing it without thinking when you make decisions about the number of stocks to hold, position sizes and whether or not your portfolio should be too exposed to banking or resources sectors etc..

luutzu · 12 December 2014

TPI said:
luutzu, I'm not sure about others, but I just consider these as two separate areas, one being portfolio construction and another being stock selection.

They are not mutually exclusive and both have their place, and I don't think you need to achieve absolute mastery in both areas.

You are right that at the end of the day knowing the business and stock selection is the important and harder part, but as you buy a handful of stocks you are creating a portfolio, and having some extra ideas and concepts to help you build that overall portfolio into something cohesive and sensible to me seems useful.

You are already doing it without thinking when you make decisions about the number of stocks to hold, position sizes and whether or not your portfolio should be too exposed to banking or resources sectors etc..

Seriously, what you are doing is very admirable. I'd do the same thing. To search and learn from others, see different point of view and take what is useful... what can be better than that? And RY is one of the guys you'd want to talk to.... could save you an entire university degree in finance and investment.

TPI · 14 December 2014

TPI said:
I have not heard of Novy-Marx, Sloan & Richardson and Piotroski, but thanks I will look them up and read further.

I had a read about the fundamental quality criteria researched by these authors, eg. gross profit to total assets, accruals ratios and the Piotroski score etc.. It's reassuring to read that there is some research and evidence-base to ones basic portfolio construction and investment approach, and this gives me some confidence. While there is debate about the reliability of different quality factors, the basic premise of merging value with quality sounds sensible, and just common sense really.

This article sums it up well:

https://www.researchaffiliates.com/...s/259_The_Moneyball_of_Quality_Investing.aspx

As I'm not a purely quantitative investor, and apply a qualitative filter to all my stock selections, I probably won't go too overboard with all the different fundamental ratios used to filter quality stocks and just stick to the ones that I can look up easily on my online brokerage account without delving too far into financial statements and having to manually extracting data and perform calculations. Or do so only on a case-by-case basis when wanting to delve deeper into a particular stock.

In any case if I were to use a predominantly quantitative approach, I think I would need to hold a lot more stocks and have a much larger portfolio, and only do so in a low-tax account like super, to minimise costs and CGT implications from the rebalancing effect.

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