Nerd Stuff: Factor Valuation Edition

I have to give Research Affiliates some serious props for their online interactive (and, yes, free tools). I mentioned the asset allocation tool in a post from earlier this week. If you didn’t check out the tool then, you really should.

I did not realize until this morning that Research Affiliates also has a similar tool for factors, called Smart Beta Interactive. This allows you to slice and dice factor strategies and also the underlying factors themselves. I highly recommend checking this one out out, too.

Anyway, this post isn’t meant to be a Research Affiliates commercial. Instead, this is going to be a post on reflexivity. Behold, factor valuations for the US market:

RAFI_1Q18_Factor_Valuations
Source: Research Affiliates

Regarding their methodology, Research Affiliates states:

Just like stocks, bonds, sectors, countries, or any other financial instrument, equity factors and the strategies based on them can become cheap or expensive. We measure relative valuations of the long vs. short sides to estimate how cheap or expensive a factor is. We find that when relative valuation is low compared to its own history, that factor is positioned to outperform. When valuation is high it is likely to disappoint.

This is reflexivity in action. Briefly, reflexivity is a concept popularized by George Soros. The idea is that by taking advantage of perceived opportunities in the markets, we change the nature of the opportunities. Howard Marks likens this to a golf course where the terrain changes in response to each shot.

Here’s how this happens in practice:

Step 1: Someone figures out something that generates excess returns. That person makes money hand over fist.

Step 2: Other people either figure the “something” out on their own or they copy the person who is making money hand over fist.

Step 3: As people pile into the trade, the “something” becomes more and more expensive.

Step 4: The “something” becomes fairly valued.

Step 5: The “something” becomes overvalued.

Step 6: People realize the “something” has gotten so expensive it cannot possibly generate a reasonable return in the future. If prices have gotten really out of hand (and particularly if leverage is involved) there will be a crash. Otherwise future returns may simply settle down to “meh” levels.

Step 7: As the “something” shows weaker and weaker performance, it gets cheaper and cheaper, until some contrarian sees a high enough expected return and starts buying. The cycle then repeats. Obviously these cycles vary dramatically in their magnitude and length.

I do not consider myself a quant by any means, but I think the two most important things for quants to understand are: 1) why a factor or strategy should work in the first place, and be able to explain it in terms of basic economic or behavioral principles; 2) reflexivity.

Many people believe AI is going to push humans out of the financial markets. There is some truth in this. Big mutual fund companies that have built businesses on the old “style box” approach to portfolio construction are in trouble. The quants can build similar funds with more targeted exposures, in a more tax efficient ETF wrapper, and with lower expenses.

What I think people underweight is the impact of reflexivity. If the AIs aren’t trained to understand reflexivity, they will cause some nasty losses at some point. Personally, I think there will be an AI-driven financial crisis some day, and that it will have its roots in AI herding behavior. We are probably a ways away from that. But technology moves pretty fast. So maybe it will come sooner than I think.

Anyway, back to factor valuations.

What stands out to me is Momentum and Illiquidity at the upper ends of their historical valuation ranges. On the Momentum side this is stuff like FANG or FAANMG or whatever the acronym happens to be this week. On the Illiquidity side it’s private equity and venture capital. If you have read past posts of mine you know I believe most private equity investors these days are lambs headed to slaughter.

There tends to be a lot of antipathy between quant and fundamental people. Even (perhaps especially) if they are co-workers. The fundamental people are afraid of the quants. Partly because they are afraid of the math (a less valid fear), and partly because they see the quants as a threat (a more valid fear). Quants, meanwhile, tend to believe the fundamental people are just winging it.

In reality I think this is more an issue of language barrier and professional rivalry than true disagreement over how markets work or what is happening in the markets at a given point in time. In my experience, the best fundamental investors employ quant-like pattern recognition in filtering and processing ideas. Many quants, meanwhile, are using the same variables the fundamental people look at to build their models.

Personally, I think anyone who wants to survive in the investment profession over the next twenty years is going to have to be something of a cyborg.

Though, come to think of it, that probably applies to every industry.

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