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Long-term historical data will give you insights for the future, says Professor Elroy Dimson. Investors should take the long view and be aware of factor exposures.
Long-term financial market performance is at the heart of Professor Elroy Dimson’s research. The London Business School professor was invited as keynote speaker at the Robeco Factor Investing Seminar to give his independent view on factor investing. He is co-author of ‘Triumph of the Optimists’ and the annual ‘Credit Suisse Global Investment Returns Yearbook’ with Paul Marsh and Mike Staunton, both also academics at the London Business School. Dimson is chair of the Strategy Council of the Norwegian Government Pension Fund, which invests Norway’s oil and gas revenues and is the largest sovereign wealth fund in the world.
Dimson gave his lecture to approximately 140 professional investors. Afterwards we took the opportunity to speak with him separately and asked him for seven key takeaways for professional investors related to factor investing.
When you average over a long period of time, you learn a bit more about asset prices, delving into something which is fundamental and permanent. On the other hand, you are looking at more out-of-date data. So there is a trade-off here. Still, because most things in investments are quantitative in nature, using more data wins compared to throwing away older observations.
Should one expect the future to look the same as in the past? No, because the past contains all sorts of events which may not recur. You can extrapolate from history to get answers to some sorts of questions. You can predict future outperformance of equities compared to other asset classes. But there are dangers. Those who predicted continued outperformance of small caps compared to large caps, when the superior historical performance of small caps was documented in the early eighties, were disappointed in the second half of the eighties and nineties.
There are three different models that investors can follow. One is the Yale Model developed by David Swensen, which explains how investment managers can bridge their deficit in target returns by hiring managers who can exploit market opportunities. The Yale Model is also about adding greater illiquidity to the investment portfolio to earn liquidity premiums which are unavailable to other investors. The Yale model is difficult to replicate because it is complex, opaque, and relies on deep knowledge.
The second model, the Norway model, which is named after the Norwegian Government Pension Fund, relies extensively on publicly traded securities, large-scale diversification, and beta or market returns. Every investor can seek to mimic this model by buying diversified equity funds, which give exposure to thousands of shares. This equity exposure and level of diversification is similar to the Norway Fund, and can be achieved at low cost. The third model, the Canada Model, relies on large-scale private equity positions which are managed in-house. It is difficult to replicate because of the scale of the required investments.
Currently, value investing is stimulated by the ‘hunger for income’. When you go through periods of huge out- or underperformance it is always good to take a long-term view. There are periods when value does badly as well as periods when value does well.
In the second half of the nineties, value investing struggled. Dedicated value portfolio managers from that period rarely lasted to see great success in the 2000s, when value became profitable again. Their jobs disappeared because they did not have good track records compared to the market–cap benchmarks, which led to fund outflows. These managers moved on to other positions.
Portfolio managers need to be aware of accidental exposures, which can have a material influence on performance. Even if a manager does not follow a factor strategy, their way of operating can lead to exposure to factors.
For example, an asset manager who reports to clients might sell his losers at the end of the quarter or year in order to window-dress the portfolio. The advantage is that a manager has less explaining to do as to why a ‘loser’ is part of the client’s portfolio. This strategy gives increased exposure to momentum stocks, and it might be good for the portfolio’s performance.
On the other hand, he might sell out of value stocks, because these stocks often attract bad publicity. In that case stocks are being taken out of the portfolio which, on a forward-looking basis, may offer above-average expected returns.
To get major exposures to factors in a large fund you will face obstacles in implementation. The reason is governance issues. If you increase factor tilts, you increase your tracking error and with it your chance of underperforming a conventional benchmark. It is hard to persuade a client and consultants why an underperforming fund should be retained. A fund’s governance should be prepared for short- and medium-term underperformance when implementing factor exposures.
The sustainability of factor returns depends on where factors come from. If these factors are anomalies, we might arbitrage them away. But if they are a reward for risk, they will continue to be employed. I still prefer the term ‘risk premiums’, because it accepts the fragility of future returns. To some investors, a focus on factors might suggest that you would just keep earning these rewards; that it is some sort of money machine.
For a large institutional investor, it is difficult to do anything more than add these factor premiums as side bets or tilts. The equity premium is more important, although you can still tilt your existing portfolio to get exposure to factors.
The Norway Fund has a major exposure to the worldwide stock market and to interest rates. Current interest rates are low and the Fund has a large bond portfolio. It would be nice to find premiums to hugely augment these sources of return, perhaps by having a long/short factor portfolio on the side. But for the largest fund in the world, extreme factor exposures would be impossible to implement. Some smaller investors may find it possible to take on larger factor weightings.
The conclusion of the seven takeaways is that the past can help to give insights into current events and the future. Or as the ‘Credit Suisse Global Investment Returns Sourcebook 2014’ puts it: ”While current events may appear different from the past, there are lessons to be learned and parallels to be drawn, especially when we look back across time and countries.”