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Breaking away from market-cap weighting is really important

Breaking away from market-cap weighting is really important

19-11-2018 | Entrevista

Mebane – or ‘Meb’ as he is known – Faber is co-founder and chief investment officer of Cambria Investment Management. In addition to hosting The Meb Faber Show podcast, he is the author of many books and articles, including the most downloaded working papers from the SSRN database1. He graduated from the University of Virginia with a double major in Engineering Science and Biology.

  • Yann Morell Y Alcover
    Yann
    Morell Y Alcover
    Investment Writer

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Your 2007 famous paper analyzed trend-following strategies, sometimes also referred to as momentum strategies. But these strategies are often criticized for being difficult and costly to implement in practice, in particular because they imply high turnover. What is you view on this?

“I think you have to distinguish between trend following and momentum. Momentum is often seen as a relative strength measure that compares two different assets. Are stocks performing better than bonds? Or is Google outperforming IBM? Trend following, on the other hand, is really a time-series version of momentum: is an asset going up, or is it going down? In essence, this is a binary exercise. So, trend following and momentum are a little different. Historically, momentum has implied higher turnover than trend following. And, depending on how you design it, long-term trend following can actually mean a pretty low turnover. For example, if you have been investing in US stocks based on trend, you haven’t made a trade in years.”

“Having said that, I don’t think transaction costs are the biggest challenge when it comes to momentum or trend following. Many of those pursuing such strategies tend to think it is an all-well-and-good investment approach. This is especially true in the wake of a bad event when trend strategies excel, which is why so many people embraced trend following after the financial crisis, and one of the reasons my paper was so popular. But at the same time, people struggle with the fact that the strategy could have multiple losing trades in a row. The percentage of winning trades is often fairly low. You often have a few large gains yet far more shorter-term losses. So, I would argue that the implementation complexity that goes with trend following is minor relative to the behavioral challenges of applying a systematic approach.”

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Do you mean that investors struggle to follow rules?

“They struggle to follow a system. For example, managed futures are often a category dominated by long-term trend following. Most of those strategies had a monster year in 2008, rising by 20 or 30%. However, they really struggled in the ensuing period. So a lot of people turned to managed futures after the crisis have since given up, because it can be painful and investors don’t like having a system that looks too different. At the same time, you have to distinguish between the different types of trend-following strategies. There are many, and trying to apply the same label to them all is too broad of a stroke.”

But would you say it is possible to time the markets efficiently using a trend following strategy?

“That’s quite a question. We argue that trend following is a perfectly wonderful strategy but for many people it’s hard to follow. We also argue that buy-and-hold is a perfectly wonderful strategy, yet is equally as hard for people to follow, although for different reasons. Buy-and-hold is a challenge because as markets decline, people struggle emotionally with just sitting on their hands. Back in 2008, some markets lost more than 50%. This can be devastating for buy-and-hold investors, as declines like this typically coincide with recessions, depressions, corporate downsizing, and job losses. It all happens at once. So, both buy-and-hold and trend following are tough to follow. This is why our flagship strategy, which is embodied in our Trinity portfolios, allocates 50% to buy-and-hold strategies and 50% to trend following strategies.”

Apart from trend, valuation is another important factor you have investigated. However, low risk or low volatility do not seem to be on your radar. How come?

“Let me back up and say that almost any of well-known factors are better than market-capitalization weighting. Market-capitalization weighting is a strategy that has only one input: stock price multiplied by shares outstanding. There is no real link to any sort of valuation criteria or business fundamentals. So, it doesn’t matter whether you opt for equal weight, value weight or volatility weight as long as you weight by something other than market cap. I don’t think there is one holy grail factor, but I think the traditional ones which have been around for a hundred years – like value, momentum and volatility – certainly are reasonable.”

“Market-capitalization weighting often exposes you to the largest holdings in the most overvalued securities. In fact, that’s the situation we have today globally, where the US stock market has the largest market capitalization. It’s over half of the global market capitalization, and is one of the most expensive markets in the world. So, breaking away from market-capitalization weighting is really important.”

In many ways, quantitative investing remains very US centric. Do you see that changing? Do quant investors outside the US have a better edge?

“One of the reasons quant investing remains US centric is simply because it is the largest economy in the world, the largest stock market and has the most amount of data. Having said that, if you have a strategy, you should expect it to work over different time periods, in different countries. And if not in all countries, at least in most of them. Otherwise, it’s data mining.”

“As you go around the world, there are two main ways you can benefit from data. One is to have better data than other investors. For example, if you have better data on the local stock market in Kazakhstan or Tanzania, you have a huge edge. The other way of benefitting from data is to have better techniques to analyze it. If you can come up with new insights that are more useful, you can also have an edge.”

“One important thing to keep in mind, however, is that different markets have different rules and structures. This is clear when comparing emerging and developed markets, yet is equally significant with developed markets. Knowing the structural biases of local markets – say, for example, the fact that Australia has many more high-dividend stocks – is certainly helpful, regardless of whether you’re are a fundamental or quantitative investor. At Cambria, we are obviously quants and we love quantitative theories. They make life a lot easier. But we don’t look down on old-school subjective fundamental analysis, although this is not something we do.”

There are many ways to make money in the market. Certainly not just one

What kind of Robeco research have you read in the past 10 years and how has it influenced you?

“I have read it all. I read everything that comes across my desk. One of the things I appreciate the most about Robeco is that it is an intellectually curious and open-minded organization. There are so many shops that pick just one approach, plant their flag, and that’s what they do forever. I personally think there are many ways to make money in the market. Certainly not just one. I also think Robeco does a really good job with graphic design. This is important because academic literature tends to offer the most boring and dry productions I have ever seen.”

And, to conclude, the toughest question of all: what is your favorite surfing spot?

“You know, I am actually a fairly terrible surfer and I go right in front of my house. I am not a morning person and you have drag me out of my coffin when I wake up. Then I’ll have a cup of coffee and go surfing. So, I like to surf in Manhattan Beach, California. A more relevant question would be about skiing, something I am actually decent at. My home state is Colorado and I grew up skiing there. But I also love exploring the world. Last year I went to Japan, which was pretty phenomenal. A lot of people don’t know it, but they have some of the best snow in the world. I would love to go skiing in Europe. Maybe Cambria and Robeco should host a quantitative research event in Courchevel or Chamonix?!”

1M. Faber, spring 2007. ‘A Quantitative approach to tactical asset allocation’, The Journal of Wealth Management. SSRN is an online database that gathers thousands of academic research papers covering a wide range of scientific fields.

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