By Jack Forehand (@practicalquant)
Last week, I had the privilege of attending Alpha Architect’s annual Democratize Quant conference for the second time. The conference brings together leaders in the fields of quantitative investing and asset management to talk about the state of the business, and to share ideas to help all of us learn and improve our investment approaches.
Given how good last year’s conference was (my summary of that is here), they were going to have a hard time topping it this year, but they found a way to do it. This year’s presenters included representatives from some of the most respected firms in the quantitative investing world, including AQR, Bridgeway, and O’Shaughnessy Asset Management.
Although the conference is geared toward hardcore quants like myself, there are always lessons that apply to all investors. Here are a few of my takeaways from the presentations.
Investing is Hard
It is hard to properly explain how smart the people who attend this conference are. When I talk to people during the course of the conference, I sometimes wonder how I even get invited. I didn’t know that having multiple PhDs in Finance and Physics was something that people did, but this conference proved me wrong.
If there was anyone who could break the investing code and beat the market every year, you would find them at this conference. But one of the major topics of discussion was how much of a struggle the last few years have been for quantitative investing. Almost all the investment factors that were discussed, whether it be value or momentum or trend following, have struggled recently. But that says nothing about their long-term effectiveness.
The long-term evidence supporting all of these approaches is just as strong as it ever was. In fact, a new study was presented that tested value and momentum all the way back to the early 1800s, and it confirmed the efficacy of both of them. If there is one lesson that any investor can learn from a conference like this it is a simple one – no strategy beats the market every year. If the smartest investors in the world who attend this conference can’t do it, then none of us can do it either.
Your Biggest Enemy is in the Mirror
One of the highlights of the conference was WisdomTree Global Head of Research Jeremy Schwartz’s interview with Jim O’Shaughnessy, Chairman and CIO of O’Shaughnessy Asset Management. Jim is a pioneer in quant investing and was a factor investor before the term existed. With Jim’s resume as a quant investor, you might think that the interview focused on things like the best factors to use or how to apply quant models in the real world. But it didn’t. The reason is that Jim understands that managing our behavior and biases trumps all of that in importance. So instead of focusing on what he has learned in his career about quant investing, he instead talked about what he has learned about how we behave as human beings, and how that can often hurt our investment returns.
I won’t be able to do this presentation justice in this article, but here are a few of the many problems Jim highlighted that prevent us from succeeding as investors.
- We are deterministic thinkers in a probabilistic world
- We want people to sell us products that fit with what we already believe
- We are programmed to follow simple heuristics and narratives
- We prioritize winning an argument over being right
- We behave predictably (and counter to our own interests) when scared
So how do we fix all of these issues? The first thing to understand is that we can’t because it is the way we are programmed as human beings. But Jim did offer up some solutions to help manage all of this. Here are some of his suggestions.
- Learn to say I don’t know
- Focus on differentiating facts from opinions
- Understand the difference between what you want to happen and what is right
- Understand that the best investment strategy is the one you can personally stick with
Someone Needs to Be on the Other Side
Investing is typically a zero-sum game. You will often hear people say that active investors tend to have more value exposure than the market, but mathematically, that can’t be true. When everything is summed up, all active managers will by definition have the exact same exposures as the market. If one manager uses a certain strategy, there will be another who does the exact opposite. In other words, there is always someone on the other side of the trade.
One of the more interesting presentations at the conference was given by Antti Ilmanen, Principal and head of AQR’s Portfolio Solutions Group, who used 13F filing data from asset managers to look at who is on the opposite side of the trade for popular factor strategies like value and momentum.
At a high level, it doesn’t make sense for anyone to be on the other sides of these trades. If these factors work in the long-term then someone taking the other side is doing something that has been proven not to work. For example, if I am buying cheap stocks, someone else is buying expensive ones. That is a losing trade long-term. If that person has a reason to make that losing trade consistently, that is a good thing for value investors because it offers the strategy the ability to keep working long-term. If that person is more temporary, it is less ideal.
So who is on the other side of the major factors? The data was inconclusive for value but in other cases, there were some interesting findings. For low volatility stocks, the data showed that hedge funds are on the other side. That doesn’t make sense given that the job of most hedge funds is to manage risk, and buying low volatility stocks has been shown to increase returns while reducing risk, but it just goes to show that even the best investors are capable of behaving irrationally. The results also showed that small investors are on the other side of both size and momentum (they tend to own large low momentum stocks).
The data used only covers money managers with over $100 million who have to report their holdings to the SEC, so the results aren’t conclusive. But it is still very interesting to begin to understand who is on the other side.
High Fee Active Managers May Want to Consider Selling Their Porsches
Ben Johnson from Morningstar gave an excellent presentation on the state of the mutual fund industry. He covered a lot of ground, but for me there were three major takeaways:
- Fees are Falling Rapidly
- Active Management Has Not Added Value
- ETFs Continue to Take Share from Mutual Funds
It is probably not a surprise to anyone that active management has largely not been worth its cost. Many studies have shown that the vast majority of active managers have underperformed their benchmarks over the long-term after fees. The big difference now is that much more is being done about it. The rise in the popularity of ETFs and falling fees across the board have made life much more difficult for active managers. And that is a great thing for individual investors. Active managers are having to justify their existence more so than ever before, and many of them won’t be able to do it. As a result, the move toward ETFs and lower fees is likely to continue, with no end in sight.
On the opposite side of the coin, another takeaway for me was that the race to the bottom in fees may be getting to the point where it goes too far. Don’t get me wrong, fees should be a primary consideration for all investors, and the research backs that up. But we are now at the point where a fund can cut its fee by less than one basis point (less than .01% or less than $10 a year on a $100,000 investment) and it will immediately jump significantly ahead of its competitors in terms of the money flowing in. And zero may not even serve as a lower bound for fees. There is currently an ETF in registration that will charge no fees, and another that will pay you to invest in it (although this one may be a marketing gimmick since it is only for a limited time).
In the end, it is hard to argue that fees coming down isn’t a great thing for investors because it is. But fees aren’t the only consideration. It is still important to understand the investment strategy of anything you invest in, especially as fees move toward zero and the reductions being offered by providers become miniscule. But if you are an active manager and you charge high fees, the road ahead will be a tough one.
The Benefits of Constant Learning
I said this in my summary of last year’s conference, but it bears repeating again. The key to success in investing is to focus on constant learning. For me, being surrounded by the brightest minds in investing during this conference was part of that process. I want to thank Wes Gray and the team at Alpha Architect for inviting me again this year and for their hospitality during the event. I look forward to attending it again next year.
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