Making Your Strategy Work: How to Go From Paper to People
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The first reason is they work because the investor is receiving a rational risk premium. Now, keep in mind, to be risky, that investment has to lose sometimes, particularly when it really hurts to lose! This is something often lost as some investors assume that risk is simply that something occasionally goes down. If you win or lose completely randomly, most theory, and basic intuition, says you are not compensated for it with higher expected return as this randomness can be diversified away.
The second reason these strategies may work is because investors make errors. Errors, mispricing, inefficient markets, overreaction, underreaction and myopia of various kinds are all in the bailiwick of behavioral finance. In this case, following our value factor example, the long cheap stocks have higher expected return not because they are riskier, but because investors make errors.
Of course, just to complicate things, these explanations are not mutually exclusive.
They can both be true. Furthermore, their relative impact can vary through time. For example, cheap value stocks might usually be cheap because they are riskier, but in the — technology bubble they were too cheap because investors were making errors. Much ink has already been spilled by researchers arguing over these competing explanations though few seem to explicitly deal with the annoyingly complex possibility of both mattering. The good news is that if something is rational compensation for risk, then there is no reason it should ever completely disappear or necessarily fall below a rational level.
The bad news is, of course, that risk is risky! But it is indeed a reason for the expected return premium associated with bearing this risk to be real. This type of strategy starts out, all-else-equal same belief in its efficacy , better than one based on risk. But it also has a big potential problem: it is likely more susceptible to going away. What might change when a strategy becomes more widely known?
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Consider the generalized idea of expected return in excess of the risk-free rate compared to the risk taken. Thinking about each of these strategies as a long and a short portfolio, 12 12 Close Again, if analyzing a long-only portfolio we can think of these as over- and underweights versus a benchmark includinthose implicit in a smart beta implementation.
The value spread is a measure of how cheap the long portfolio looks versus the short portfolio and for some factors can go negative.
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For value strategies the long portfolio always looks cheap, that's by definition, but how cheap, or the "value spread," varies through time. You can think of the value spread as one potential way of measuring the crowdedness of an investment. If too many people buy the long side and sell the short side, the long side gets bid up and the short side bid down, squeezing the value spread. A tight value spread should logically lead to lower long-term average returns to the factor going forward. But, lower does not have to mean irrelevant or disappearing.
That will depend on how many investors on net are trying to lean this way. As of now, in broad generality we expect to write more on this soon we do see spreads on many factors somewhat tighter than they have been in the past, but not shockingly so in fact, in our main example today's spread is almost exactly at the historical median. Moreover, they are considerably less tight than are the valuations of long-only stock and bond markets versus their own historical valuations. But some, like the difference in valuations instead of the ratio of valuations between the cheap and expensive yes micro stuff like this matters!
In other words, if value spreads on these known factors are somewhat tight versus history, they are not, in our view, nearly as tight as traditional markets are expensive versus their own history. Still, if the cheap stocks looked way less cheap versus the expensive stocks than ever before, we might not panic or abandon a strategy, but we would certainly pay attention.
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You get essentially the same graph. The red line is the median, and higher implies cheap is cheaper than usual versus expensive:. The current level is almost exactly at the year median. While the strategy might be more exciting to invest in at times like the peak in — or the milder but still famous growth stock frenzy of the late s and early s, one usually has to suffer greatly before those opportunities turn profitable!
Does it go away entirely, get reduced significantly or is it only mildly affected? What happens to the denominator risk is perhaps a bit less obvious. There are more candidates to start running, and more price impact of the run, which can itself stimulate more running. Fertile ground for future research. That is, unique strategies seem relatively immune from runs, and the chance of a run seems logically to follow a strategy becoming known. Besides runs, there are other more mundane reasons we might rationally worry that risk would increase when a strategy gets known.
Consider the value strategy again. Even in a world where nobody else is doing it, there is still risk. The expensive stocks could turn out to be worth their prices, or more than worth them, and the cheap stocks could be not cheap enough. Even if a strategy is known only to you, it is still buffeted by real world news and outcomes and even just changes in opinion. If a lot of good and bad news comes out for your short and long positions, respectively, then you lose at that time. Now imagine that a strategy becomes well known and popular. What we mean by flows is somebody raising or lowering an allocation specifically to the factor in question or some version of the factor: an allocation away from capitalization weighted and to fundamental indexing, for instance, would affect all value strategies implemented over the same stocks because fundamental indexing is simply a value tilt.
This can happen quickly should the return reverse fast as price-pressure abates, or slowly should the inflow compress the value-spread discussed earlier. Outflows, of course, work the opposite way. Essentially flows now become a new source of day-to-day volatility. We think this, like flows in general, affects volatility and diversification over the short term way more than over the long term.
The chance that these strategies do well or poorly when the market does well or poorly over longer periods is likely not affected very much by this change — though it is again something to monitor and worry about. Events are about survival, the long term is about prosperity.
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How much higher is an empirical question. We know they occasionally matter a lot e. But how much do they matter in more normal times when a strategy is well known? That will depend on their magnitude and also how correlated they are to contemporaneous performance if positively correlated, their impact will be to exacerbate current moves; if negatively correlated, as if investors were net short-term contrarians in the strategy, they could even dampen volatility.
Indeed, there could be a strong feedback loop where crises or some extreme positive event are an interplay between performance and flows that is large and continues for a bit. This is all important stuff for future work. Just as we did earlier for the value spread, we can examine the realized volatility of the value strategy. There are lots of ways to do this, but here is a basic and obvious way.
Below we plot the realized, rolling 5-year monthly volatility annualized of long cheap, big stocks and short expensive, big stocks again, using the Ken French data :. Again, the technology-driven — period is the outlier. Smaller extremes happened in the late s through early s remember the graph looks back five years and during the — financial crisis.
Also, note that the rolling volatility of the value factor is 0. As a strategy becomes well known it leads to a potentially lower numerator expected reward and — probably less obviously — a potentially higher denominator risk. Does the numerator have to go to zero, or the denominator so high that the risk is unacceptable?
The above is some very early evidence that, at the very least, this has not occurred yet for the most basic version of the most widespread smart beta, or factor, which is value. First, we think the evidence that these strategies are flooded with money, as compared to the past, is weaker than many critics believe. These strategies have been well known since the late s.
I was miserable! Am I doing something wrong? Spend as much of your time as possible in that sweet spot, and work will become a rewarding endeavor. Great Article!
Loved the Discussion and Advice! Will try that today! Leaving the armed forces and getting my civilian job which luckily was enjoyable, and something I excelled at, it never dawned on me that puctuality would be a problem. Of course it was so when my first job evaluation arrived and by then i was now replacing 2 people the supervisor told me how pleased they were.. Time cards were not used but it was very noticeable when i came rolling in 15 minutes late often. I promised I would and was awarded double the normal raise at the time. I lived 10 minutes walking time from work.
Well a year later and our baby who was now one years old and would not sleep at night for another two years, was on the scene. I had just bought a house anticipating another raise to help pay for it along with my Taxi driving 4 nights a week. We sat down for the interview and agin he emphasized how pleased he was with performance my Math skills are savant like and again the issue of timeliness came up. I explained the baby problem and he was more than accepting of this issue.
He however suggest that it would be better to come in the back stairs door so as not to flaunt the priviledge. That raise and promotion and another the following year doubled my original salary as this place valued performance beyond anything. That was 50 years ago and many places still do. Great advice about making sure it was the right work place.
And 50 years ago adhders including me seldom graduated Highschool much less university as education tolerance about homework was non existent. The armed forces training seemed to even the playing field at places i applied for that required a university degree or HS Diploma. How did i pick out this job and how did I know it could be the right job.
Three things worked in my favor. When I left this city I had a large group of friends similar in age, some of whom had started work immediately upon graduation from high school. I had also worked two summers in a mining hardware warehouse, training similar to my armed forces trade and was also not overly fond of this.
I had lined up two jobs one in Healthcare of the HO of a very large insurer and the other in parts and stock control of a catepillar dealer.
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Choice was easy to make and the result landed me 9 years of technical administration and claims experience, which led directly to my next job as a consultant and eventually Senior executive with a major actuarial and consulting firm. Working for many clients i left this job 9 years later to form first a business partnership and later my own consulting business. Although this began in i was still using some of the knowledge i gained in my first few years 35 to 40 years later and no one person could fire me.
I did learn to deliver reports on time though. Best of all the timeliness and many of the other weaknesses we have were attended to by staff who i employed to manage me. Doing the job i loved. As i often said to my business partner its a good thing they dont know I would do this for free i like it so much. A few years later following a major bout with cancer I made a concious choice to work no more than hours a year to hours is the expected norm in the industry.