Friday, December 6, 2013

Testing Small-batch Artisanal Portfolio Construction With Cliff Asness and Grantham, Mayo's James Montier

As usual, apologies to Mr. Van Otterloo.
From FT Alphaville:

Smart beta-blocking
We are big fans of index tracking, particularly for those cash strapped and socially sensitive large pension funds, and we are far from alone: passive is massive for a reason.

But where there’s a fee there’s a way. As alternative investments suffer the slow zombification of poor performance, active managers have been trying to find a way into this passive game, prompting some elegant demolition.

First there was the list of Clifford Asness who, in a rant at the world’s refusal to be sensible (we sympathise), presented pet peeve number six:
If you deviate markedly from capitalisation weights, you are, by definition, an active manager making bets. Many fight this label. They call their deviations from market capitalisation—among other labels—smart beta, scientific investing, fundamental indexing, or risk parity…
You can believe your strategy works because you’re taking extra risk or because others make mistakes, but if it deviates from cap weighting, you don’t get to call it “passive” and, in turn, disparage “active” investing.
Then hot on his heels arrives the latest from James Montier of GMO, a weighty demolition of several forms of snake oil.

First up is the smart beta crowd, who have really just been taking bets on small companies and value stocks. As movement of the S&P500 is dominated by very large companies, doing things like equal weigh investing – putting the same amount into each of the 500 S&P companies, for instance – produces outperformance.
There are also things like minimum variance, maximum diversification, etc, but we won’t bother explaining them because, as Montier says:
The unifying trait of these approaches is that they build portfolios with indifference to price (i.e., they ignore market cap in portfolio construction). Such a process essentially guarantees there will be a value and a small cap tilt to the portfolio....MUCH MORE
And from CXO Advisory:

Measuring the Value Premium with Style ETFs
Do popular style-based exchange-traded funds (ETF) confirm the existence of a reliably exploitable value premium? To investigate, we compare the difference in returns (value minus growth) for each of the following three matched pairs of value-growth ETFs:
  • iShares Russell 2000 (Smallcap) Growth Index (IWO)
  • iShares Russell 2000 (Smallcap) Value Index (IWN)
  • iShares Russell Midcap Growth Index (IWP)
  • iShares Russell Midcap Value Index (IWS)
  • iShares Russell 1000 (Largecap) Growth Index (IWF)
  • iShares Russell 1000 (Largecap) Value Index (IWD)
Using monthly adjusted closing prices (incorporating dividends) for these ETFs during August 2001 (the earliest month available for IWP-IWS) through October 2013 (147 months), we find that:

The following table summarizes the average monthly value-minus-growth return spreads and standard deviations of monthly return spreads by capitalization category over the entire sample period, along with average returns for two equal subperiods. Over the entire sample period, the average return spreads are positive for all three pairs. However, averages are very small compared to monthly variabilities, weakening any conclusions. The large differences in average returns, including sign reversal, between the first and second halves of the sample period undermine belief in a value premium exploitable via style ETFs.
For a closer look at trend, we measure the value premium by month over the sample period.
The following chart plots monthly value-minus-growth returns by capitalization category across the entire sample period, along with associated linear best-fit trend lines. All three trend lines have negative slopes, suggesting that the value premium has weakened or even reversed over the sample period. It is possible that the introduction of style-based ETFs has made it easy for investors to pursue, and extinguish, any value-related abnormal returns. The sample period is very short for such trend analysis in terms of any underlying economic/market cycles....

...In summary, evidence from simple tests with available data (about 12 years) does not support a belief that investors can reliably capture a value premium via style-based ETFs.
Cautions regarding findings include:
  • The criteria for constructing/rebalancing the ETFs may not be suited to exploit the value premium efficiently. For example, as pointed out by a reader, it may be that capturing the value premium depends on excluding financial stocks as done in many academic studies but not done in forming these ETFs (financial stocks tend to concentrate in the value ETFs).
  • As noted, the sample period is very short for reliable measurement of a value premium that varies with some long economic or market cycle.
It appears I'll have to stick to the cheese and bourbon.
(GOOG search for "Small-batch Artisanal" = 1.4 million hits, some quite strange)