Combining Best Stock Selection Factors Patrick Oshaughnessy Quantopian

TITLE: “Combining the Best Stock Selection Factors” by Patrick O’Shaughnessy CHANNEL: Quantopian DATE: 2017-03-06 ---TRANSCRIPT--- oh oh oh all right uh so we’ll get started um right about now uh so I’m very very happy to be able to introduce to you Patrick oesi he is the principal and portfolio manager at oan Asset Management he has also published um a book called Millennial money how young investors can build a fortune um published by pal gra MC McMillian is that how you say it great I got I got there uh he’s also a contributing author to the fourth edition of what works on Wall Street so without further Ado Patrick Shi thank you so thanks thanks uh thanks for joining me this afternoon so what I’m going to talk about today is stock selection factors in the equity world I think this is a a important topic today because while this used to be um a strategy which was very very fertile ground meaning if you had come across this strategy 20 or 30 years ago it would have been probably one of the best ways to oper form the market it has become very common ground uh arguably over farmed or overmined ground for trying to earn Alpha uh in the US and international Equity markets so I’m actually going to talk about the ways that the industry I believe has misused this idea of factor investing so broadly speaking buying stocks both long and short um or building long short portfolios based on factors like valuation momentum quality low volatility uh being some of the most popular factors out there today and why instead future potential Alpha in this style of investing will look very different it will look more concentrated so smaller portfolios of stocks that exhibit a lot of different characteristics and ideally stocks that have factors that have not yet been identified and commoditized Away um so this used to be a really really really great way to put your money into a simple you know value portfolio and and stop worrying about it and the question is is that sustainable for the future so we’ve spent um the better part of 20 years or so running money so about5 A5 billion dollars today uh on this idea of quantitative very systematic invesment strategies and the idea is simple that you find key characteristics or common DNA of stocks that have tended to outperform and you just constantly rebalance towards portfolios that of stocks that have those character istics in any given Market most of this is done at first using back test so you get big historical um data sets financial statements price data on companies going back anywhere between five and eight decades you find the best stuff you build portfolios around them having spent with a couple of the other presenters here today I’m sure more time than I probably should have with this data through history I can assure you that back testing looks a lot like this funny cartoon where you see great results at the top level but once you start actually digging in to what’s driving those results often times it’s micro cap stocks that you can’t trade as an Institutional Investor uh or there are data issues or huge sampling issues um there are so many problems with building a strategy around just a back test um and unfortunately that’s become probably the most common way for big institutional asset managers to Market new strategies because it’s very low cost for them it’s very easy to set up a rules-based system that does something with a portfolio manager at the head of it uh who can somehow manage portfolios of 10 or 15 or 20 or 30 different ETFs um so it’s a very scalable business model to build you know an alternative to a simple market cap weighted index but unfortunately I think that because everyone knows about these things the excess return that the strategies have earned in the past may be to some extent jeopardized in the future I certainly don’t think it will go away and I’ll describe why but I’ll walk you through kind of the evolution of this idea of factor investing and how we think you should instead use factors to combine into an overall portfolio so first of all this just to kind of level set with this this recent Trend or deterioration I’m talking about with factors this is five very big broad widely accepted factors that you can get this data is on F French’s website um sort of the big five if you will for investing strategies for Factor investors momentum operating profit which is basically a measure of quality um investment which is kind of a counterintuitive one you actually want to buy firms that have falling um long-term asset bases and you want to avoid firms that have the biggest ramp UPS in their asset bases so you know biggest growth in Goodwill a lot of growth in CeX uh Etc they tend to be very expensive size small cap a little bit has tended to outperform large cap and value book to price being the the most common factor there and what you’re seeing here these lines going all the way back you know many many decades is the annualized rolling 10year long short spread between best and worst so you can see for this kind of whole initial period let’s take book the price as the example that’s that’s the purple line you’re earning this kind of incredible and very steady long short spread by doing nothing more than being long the cheapest stocks cheapest desile of Stocks by Price the book and short the most expensive desile sort of an easy way to earn incredible long short returns and then you could see what happens and i’ I’ve kind of broken It Out by interest rate regime so rising Rising secular falling secular and then this zero interest rate period but more importantly what you see is this massive deterioration of these long short spreads so pretty much all at once these factors that were sort of the one markets version of a free lunch if you could have somehow identified them many decades ago have stopped working to a considerable degree versus their long-term history and this should be very alarming because when someone knows about something when everyone is agreeing on one way of investing money often times that gets this happens with stocks often times they get very expensive and any Edge that you may have had is very quickly eroded in the overall market so when you see this kind of erosion you should you should take pause you should wonder whether a strategy like this is going to perform in the future now there are very specific reasons why some of these factors have failed so I’m not a believer in the size Factor you can see here that it’s it’s certainly the least consistent the Blue Line most volatile selection Factor historically and we happen to be sitting at the tail end of a time right now you know in 2016 where large cap c09 has crushed small cap so it’s been a great time to be a S&P 500 or an indexed investor but the rest of these have are pretty solid factors especially these ideas of value momentum and quality I would Define quality very differently than F and French and kind of the academic literature does but those are really good well proven long-term ideas for investing buy cheap stuff that’s not completely junk quality you know not over levered to the hills and buy it when it’s trending so something can can stay cheap for years and years wait till it has a bit of an uptrend just the beginning legs of a positive trend in the market and buy it that’s been a really really solid strategy but they can suffer and you can see this deterioration happen fast so this is the average long short spread so 10% on average really good in rising and falling rates but more recently very small there’s an amazing amazing book that if you do anything from this talk what you should do is go read this book it’s called the misbehavior of markets by a guy named a fractal geometrist mathematician named benois Mandel BR it is the best book you will read about markets um and it it one of my favorite quotes is that the trend has vanished killed by its Discovery that’s what happens in markets all the time when there’s a big Advantage people become aware of it they put a lot of money behind it that bids up the valuations typically of that idea or factor and then it doesn’t work in the future mean reversion is as they always say book to price I think is the most interesting example of a law that that’s called good heart’s law so good Arts law says that when a measure of something becomes a Target it ceases to be a good measure so there’s a lot of examples of this maybe the most tragic one in the US is that home ownership for decades and decades was a measure of happiness a quality of life it became a Target that Congress and and the financial uh World sought to achieve for everyone and we know how that ended my favorite examples were in in colonial India and Vietnam so in Vietnam they had a huge rat infestation problem and so the government said we’re going to offer a bounty on rats if you deliver a rat’s tail meaning you’ve killed it we’ll give you 20 bucks so what people did wasn’t kill rats they just chopped their tails off turned in the Bounty and let the rats go back to breed so that their Bounty pool would increase same thing happened in colonial India it was with Cobras they said bring us a cobra and we’ll give you this bounty well what people did was they started breeding cobras Cobra Farms so they would they would breed cobras kill them turn them in for the Bounty and then the Bounty payers realized this was a terrible plan said okay we’re not paying any more bounties they the Breeders released all their cobras and the population was bigger than when they started so there’s always these unintended consequences when a measure becomes a Target and arguably price the book The Price to Book factor which was originally held out by F and French in 1992 as the seminal value Factor it had a lot of great features at the time and if you had looked at a menu of value factors in 1993 which I’m sure F and French did you would have seen that since the early 60s value factors had all provided a pretty similar amount of historical annualized excess return so you could choose book earning sales eida whatever you wanted to choose it was a pretty effective strategy no matter what they chose price the book because it’s got the lowest turnover so you could build a portfolio around it turn it over 10 20% a year lower trading costs Better Tax efficiency and so on and here’s what’s happened to those same factors so this again excess returns F and French publish their paper so exact very similar clustering of returns prior to the paper hundreds of billions of dollars including a a couple massive asset managers that I’m sure everyone in the room is familiar with had built strategies value strategies based on this idea of price the book and you can see that since that time it’s been by far the worst performing book factor or value Factor you hear all the time as we do on like quarterly calls with clients that value has been getting killed by growth and the reason people say that is is because of Price to Book they talk about the Russell 1000 or 2,000 growth versus value where growth has one but if you had used anything except for book for that same calculation over the last 10 years which is this period people are talking about that story goes away if you had swapped sales in for book for example for the last 10 years your returns would have been 100% cumulatively better so it’s always a concern when a strategy when a factor when an idea when anything becomes too popular and becomes a common uh Target for asset managers because very often what you see coming out of that popularity is an erosion of an otherwise strong historical Advantage the problem with momentum so that’s value the problem with momentum is that it can be absolutely excruciating to live through certain periods um certainly long short but even as a long only momentum investor these are inversions in momentum that all have a similar feature back to the 20 so all these circled periods uh and this is this is not an exaggeration so the long short spread was negative almost netive 500% in one year for momentum coming out of the Great Depression in 2009 uh and I run momentum portfolios so I can assure you this was excruciating long short momentum underperformed by about 200% so what happens is the market goes down 40 50% Market realizes that the world’s not going to end the stocks that were priced like the world is going to end bounce off the bottom think Ford Bank of America City Etc in 2009 they’re up four 5 6 7 100% you’re short those stocks you’re long the stuff that had protected into the decline which were barely flat uh in 2009 so you have these unbelievable inversions in momentum if you think back to that first slide that you saw momentum tailing off as an effective Factor that’s entirely because of really like a five Monon period of time since then momentum’s actually held up very well arguably it’s been the best uh performing stock selection Factor but momentum can be exceptionally painful and this is true of most of these factors in general you take makes huge discipline to profit from these things I would argue that most of the profit from Factor investing has gone to sponsors or fund managers who use these strategies because they’re selling uh raising Assets in these strategies charging fees and doing very well for themselves the investor returns if you will time weighted versus dollar weighted returns have been horrendous so even with clients of ours quite honestly now we’ve worked hard to build a much longer term Capital based clients that really understand what we’re doing but like any strategy people pile into something after it’s done really well they pile out after it’s done badly that has been the big issue with Factor investing like any other style has then has been that people have not been able to stick with it because you have to live through stuff like this so I’m going to talk to you instead about um a very different Factor because I think the goal of anyone that’s trying to do systematic investing especially in the equity markets is trying to do something a little bit different um and ideally do something that is not scalable that cannot cannot be commoditized away because there are not enough companies that meet the criteria of the type that I’ll talk about so value momentum very popular investing strategies one that we are well known for and kind of hang our hat on is this idea of capital allocation um so this is really getting in it’s going to sound I’m going to sound not maybe not I’m at the wrong conference not a Quant conference but a fundamental conference it’s going to sound like a fundamental analyst might look at a business but we like it from the perspective of a Quant because when you think about Capital allocation there’s a fairly limited menu of options so we can test how companies mix these options sourcing and spending Capital so how can you Source Capital well you can get it through normal business operations that’s arguably the best kind internal financing we call it you can use debt you can use equity and you can use float so maybe float’s the best it’s interest free financing payables Warren buffets famous for using float to to fund uh Berkshire hathway that’s really it on the spending side you can spend on capex R&D you can acquire other businesses uh pay down Debt Pay div dividence repurchase shares that’s kind of the major menu and the question we have have asked ourselves is what mix of those different options has worked out best for the shareholders of those businesses so value is great momentum’s great but what about how businesses allocate their Capital because they’re investors too just like we are this is some interesting very very admittedly very high level results for some of these categories these are annualized excess rates of return good and bad versus US large stocks so this isn’t a small there’s no small cap effect in here is Big us companies companies that dilute their existing stakeholders issue a lot of equity issue a lot of new debt have underperformed between two and 4% per year companies are the biggest what we call Empire Builders so biggest growth in their long-term asset bases most capex biggest aggressive expansion often at the wrong time at the peak of cycles and companies that the most inquisitive often again at the peak of of uh business Cycles have actually underperformed that one often surprises people the most because you think well investment for for the future you need to spend often to grow and if you want long-term growth you need capex capex isn’t evil but the extremes of capex growth do tend to be evil so you want to avoid companies with the highest uh rates of investment in percentage terms year over your growth then you get to finally some good excess returns which is businesses that we would argue have more disciplined Capital allocation are returning cash uh to to by paying down debt and they’re spending a huge amount of money on share repurchases this next slide always gets botched so I’ll skip it um the the idea behind that slide was and probably the most important factor in all of this Capital allocation is share BuyBacks which you probably read about in the news it’s become a popular Whipping Boy um of of Corporations buying back their shares and most often painted in a negative light that they should be reinvesting that this is financial engineering they’re issuing debt to just buy back shares it’s almost always negative what we find is that for the most part we agree but there is a small sliver of stocks and again remember I said you want stuff that is not scalable you could not uh ey shares could not launch an ETF that could accommodate much money in this kind of strategy stocks that are repurchasing a massive amount of their shares outstanding net of any issuance net of any goofiness with employee options or anything like that that also trade at very cheap prices with decent quality has been an incredibly powerful combination for stock selection historically so companies that have a more disciplined Capital allocation that aren’t overspending and that are recognizing a current discount to their intrinsic value by repurchasing sometimes 10 15% of their shares outstanding that category very overlooked and has tended to do very very well this is a distribution of the relative price this is kind of maybe too complicated for this but I’ll go through it anyway it’s the distribution historically of the relative price paid by different companies buying back their own shares at different levels of conviction so let’s say you’re rep purchasing a billion dollars of your own stock if you’re Apple arguably that’s a very low level of conviction in your stock it’s 1600 or whatever the market cap is today of their overall market cap if you’re Parker hanifen or north of Grumman or a much smaller say 1010 billion stock repurchasing a billion dollars arguably you’re making a much bigger bet in your own share price one10 of your total market cap in the example of the 10 billion stock so we Define conviction between 0 and 5% of shares 5 and 10 and then 10 plus 10 plus being very rare but exceptionally High conviction this is the distribution of all large stocks so it’s flat this is valuation so anything plotting here would be the cheapest 5% of stocks in the current market most expensive 5% of stocks right now this these two lines are the high conviction group and this is the low conviction group so the low conviction has almost no skewness here towards preferring to buy back stocks at cheap prices they’re just kind of doing it because that most large stocks these days are doing it there doesn’t seem to be a valuation play they do slightly avoid buying back expensive but look at the the skew or the preference for high conviction buyback firms to re repurchasing their shares at very cheap prices this is exactly the kind of category of stocks that we’re after because what they’re doing is saying let’s reduce share count by 5 10 15% but do it while we’re trading in the cheapest 5% these are pees of 678 you know price to sales of. 3.5 really cheap relative prices versus the overall market and there has been a very big difference historically in the returns of these different kinds of businesses so all large stocks over the last 30 years or so 11% return net issuers so companies that are diluting their shareholders have underperformed by about a percent the low conviction buyback firms have outperformed by about a percent but the high conviction category has done much better outperforming by about 5% per year annualized again versus large cap stocks this is a hard Market to beat arguably if markets are efficient to any extent the most efficient market Market in the world is probably the US large cap market so an incredible degree of excess return for a pretty interesting factor that typically is not represented in a portfolio of someone that calls them a factor investor this works exceptionally well with value so a quick word on value investing um which is probably the most popular form of quantitative investing because it’s been around the longest um and it has great philosophical roots with guys like Ben Graham and Warren Buffett we think of value investing as as putting yourself out there as the house in Vegas the house in Vegas to take Blackjack as an example has a one maybe one and a half% edge what they do is they turn that very small Edge into a massive cumulative Edge over time through volume right so they know they’re going to win over time because the odds are stacked in their favor in the short run they can get destroyed right so someone can go on a run and we would use a grow stock as an analogy here a Facebook or something like that a stock can or a gambler can go on an extreme run in the short time but over the long term that the house is going to win value investing looks very much like that so actually only about 51 52% so just like Blackjack percent of value stocks as we Define them have beaten the market historically but if you let that in shorter periods of time if you let that compound over time we’ve actually never seen 10 or 15 year periods where these kinds of stocks have underperformed the market as a group so if you bought a big basket of them this is the distribution of value and growth so value is much more peaked this line is is zero so anything to the right of here uh is outperformance I mentioned that’s about 52% about 48% growth has a has the the bad kind of distribution that you want to avoid but a fatter tail on the right so there’s more examples of growth stocks doing exceptionally well arguably this is what keeps people coming back to the casino tables in Vegas it’s the same thing that keeps people coming back uh to buying stocks like Facebook like Tesla today you know pick your favorite example almost the first question we get on any call or talking to advisor or anything like that that might use a strategy of ours is well won’t this process systematically Miss stocks like Facebook and Amazon and Google and so on and the answer is of course yes it will but we don’t care because we’re not interested in individual outcomes we’re interested in putting probabilities on our side so by definition to do that you have to acknowledge that you’re going to miss some unbelievable Returns on the right hand side of this distribution but you also know that you’re stacking the odds in your favor so value works really really well interesting that when you look historic at the returns um in an earlier talk me fa was saying that one of the great things about value is not just that cheap stocks outperform maybe even more so it’s that expensive Stocks underperform by so much so if you’re willing to build a portfolio that’s not just a tilt of the market but is a true often painful painful to buy and often painful to own deep value portfolio not only are you getting longer term returns over here but you’re avoiding the stocks that tend to fall in this category um yeah question which valuation metric is that based on price book or Price sales so it’s a combination of four um it’s sales earnings EIT do and free cash flow just equally weighted so for those factors like trailing mon price B yeah share BuyBacks is that a similar thing like the last 12 months of share BuyBacks or since companies announced their share buyback plans do you look more at what they claim they’re going yeah so same look back period 12 months you can do it shorter you can do six months U there are blackout periods for when firms can repurchase their shares so you don’t want to go to a month or something like that um you can go back further two years but one year really does work best because you want actual activity so you definitely do not want to act on announcements um there’s studies that show you know 26% of announced uh BuyBacks ever actually happen um so it used to be a signaling tool SEC got a little harder on firms repurchasing shares now they have to disclose it monthly and that 26% come up um but you don’t want to do it on announcement so it’s a 12-month look back so that’s the that’s the distribution and and so I wrote a book called Millennial money that focused on young investors and and maybe one of the issues is that new generations keep making these same mistakes over and over again so what you’re going to see on the next slide is the most Own St or stocks that have the youngest median owners and where they plot today along this Continuum so these are the stocks that young people own the most of and where they sit and kind of the relative excess returns that those categories have earned historically um Apple arguably it’s just because the float’s so big you you have to everyone owns some apple uh but all these stocks are extremely popular and fantastic companies uh but there is a huge and important distinction between a good company and a good investment uh and price is definitely squarely on the wrong side of these kinds of stocks and then as people get older so these are the stocks that have the oldest median owners which is about the most boring portfolio I couldn’t I couldn’t script a more boring portfolio than this um but much cheaper on average than stocks that young people tend to prefer um so maybe this is just a big generational wheel of Wheel of torture um that people don’t realize till later in life uh maybe too soon to when they’re going to be selling their stocks that they should own cheap stocks ask you a quick isn’t that isn’t that just a commentary on also just the way the market at the end of the day values assets because to me I look at this and say you know when you go back to the basics of Finance instead of DCFS and what what are what we put numbers on what a business should be worth right an aggregate it’s correct and that’s all this is saying because every time you overpaying for some future future returns you don’t get them and every time you pay some fair value or you know lower median you you get the return you expect so there is an element of you know I think that um Back to Basics it’s an overuse quote but it’s right which is that in the short term it’s a voting machine in the long term it’s a weighing machine and the problem is that that weighing machine is very longterm so over the over a multi-decade period yes stock returns tend to follow basic fundamentals like earnings growth but for long periods of time they can have huge swings around earnings growth rates and so for all of you who are probably here because you’re interested in outperforming markets uh or in systematic trading strategies I think things that take into account psychology price um sort of current opinions that tend to overdo it at extremes is the far more interesting way of profiting from all of this uh but maybe you know maybe maybe it’s just laziness at the end of life you just touch it less and it tends to get cheaper more seasoned companies so one interesting thing is that value which again using the Russel as a proxy has underperformed is actually interesting starting to look a little bit interesting again so one of the things that we look at is the spread between cheap and expensive stocks um so arguably you want that spread to be wide right so the value strategy works when spreads are wide and they start to narrow right so valuation ratios converge for a long time in the last you know three four years they’ve been very very low not at historic lows but but low and then in the most recent period now a lot of this is energy and materials um but they have started to spike up pretty aggressively um so maybe good news for longer term value investors that we might finally starting to be able to um uh take some opportunity buy some cheap stocks again and expect to outperform here’s what happens when you combine these ideas um so high shareholder yield we like cheap prices we like if you buy High shareholder yield and and cheap you know good return 13.7% you do much worse if you buy High shareholder yield at expensive prices so if if it’s a high dividend yield and a lot of BuyBacks but it’s otherwise really expensive that’s been a really bad sign historically you want to avoid it the way this all then rolls together into a strategy and I’ll close talking about how you actually build a portfol folio is these are the things that we look for cheapness uh momentum we talked a little bit about quality I won’t go into but it’s a whole another um kind of more fundamental oriented looking at balance sheets looking at um accounting choices um kind of preferring High cash earnings Etc and then this idea of shareholder yield so we build portfolios around that the difference is between us and and most quants and probably the biggest philosophical disconnect is most quants famous and otherwise that you get in here with that factor investing or quantitative investing is all about broad diversification and and averages that you want big broad exposure um to hundreds of stocks long and short so you’re not taking any individual name bets uh you get higher information ratios doing it this way um you know you head you can hedge out industry risk all this other stuff we actually disagree we think that the future potential for these kinds of strategies is to be more active so there’s a concept called active share which has become very popular in in the um in the equity World which is basically a number Z to 100 that measures how different you are from your benchmark so let’s say it’s the S&P 500 an active share of zero is is an index fund it means there’s 100% overlap between you and the market an active share of 90 means you are extremely unique means that there’s only 10% overlap between your fund or or hedge fund or whatever and the S&P 500 now the industry’s trend has been towards lower active shares something called closet indexing so there’s this hug huge problem in our world of principal agency risk I’m a fund manager I want to keep my clients and to keep charging fees through run a good business if I have a more active portfolio which opens up the kind of the cone of potential excess returns good and bad if I strike one of those bad years the odds of my being fired go up very quickly right and this agency risk has created this trend towards closet indexing where people build portfolios that look more like the overall Market it probably means they’re not worth the fees that they charge but it also means means they’re less likely to get fired in any given year active share is not a predictor of future excess return but it is a good predictor of potential future excess return so what this is showing you is we ran an Optimizer to say okay in any given year and this is just the average of all those observations at different levels of active share so 10 20 all the way up to 90 what is the maximum possible excess return that I could earn in any one year so you see that there’s always this upward sloping line it varies but the averages that as you get more active your potential gets better and better so if you’re going to hire someone that’s a 20 30 40 50% active share manager you should probably arguably pay less for that manager because their potential is is uh is less now this Cuts both ways right so the same is true on the downside that more active the more uh underperformance you can have versus the market and this is actual performance of all mutual funds over several decades by their active share so you can see that cone I was talking about where if you’ve got a you know if you’re an index on you’re obviously going to look just like the market as you get more and more active the chances of doing really good or really badly um widen and arguably if you’re going to pay for active management which fewer and fewer people are doing you want at least the potential of earning excess return in the portfolio and then the question is well how do I get on the right side of this distribution curve and we think the answer is factors that are a little bit more unique different takes on quality and value this idea of high conviction BuyBacks Etc find your own factors that’s the whole Magic of of all this research world that that we’ve uh evolved into but this cone is really important and the net result is that we think you should go a different way than the industry has so everyone knows Morning Star Charts which show you a little dot that’s the average usually it’s small mid large and then it’s value core growth and it’s a little dot that says okay here’s where it plots on average and then the circle is 75% of the funds Holdings so smart beta you’ve probably all heard that term it’s mostly most of these Factor investing strategies are are terms smart beta they have hundreds of Holdings a lot of overlap with the market low active shares uh but charge active fees or at least more active fees these are some smart beta options so we’ve got the Russell 1000 that’s just the market Russell one value arguably the first smart beta strategy um the Tilt towards value using Price to Book and then a very popular one from research Affiliates called the Rafi 1000 which is tilting again towards smaller and cheap stocks you see you know a little bit of a of a pref for what we want which is down here good shareholder yield great value quality Etc but a very broad exposure to the overall Market we think you should build instead portfolios like this much more clustered around stocks with the best overall characteristics these could be as few as 50 Holdings in the overall portfolio it gives you a much tighter exposure to the things that have worked well historically the downside and probably why you don’t see more of this is that it’s not a scalable strategy so this cannot accommodate the kind of assets that the major sponsors of ETFs and even mutual funds um want right so you want to launch something that has the potential to have $50 billion in it um to be able to charge fees on this is not that kind of strategy even in large cap um it can still it can accommodate billions but uh not not tens and tens of billions and in small cap you’re talking maybe a billion or two worth of assets in a strategy like this and I’ll close by showing you a sequence of of of plot points where um this is where the industry’s gone and then I’ll show you what we prefer this is every stock in the S&P 500 where it plots on that Continuum so this would be best down here at least in our way of looking at the world and the size of the dot is the weight of that stock in the index so there’s the S&P 500 there’s the Russell 1,000 value so you can see a little bit of a tilt start to happen you see less in the upper right so you had some bigger weights over there that the Russell 1000 value is avoiding but still very broad exposure there’s fundamental index so again a little bit more of a tilt towards that bottom left there’s a very popular ETF these days called um minimum volatility so very low volatility stocks which also happen to be as expensive as they’ve ever been in recorded history and there’s the approach that that we would Advocate which is one that is again much more focused in the kind of narrow corner you see some outliers right so you rebalance this thing infrequently annually or or less often usually the holding period is a year and a half two years something like that so for example this is a stock called XL group an insurance company uh had great shareholder yield was buying back a lot of shares in May of last year it issued a bunch of shares in a cash and stock deal to acquire another business um so 10 months ago 11 months ago that dot would have been like this down here and it’s drifted and gotten smaller because the rebalance process the kind of quantitative systematic process slowly reduces weight to names like that um so this is the approach that we think will work in the future it may not work as well as uh these strategies have worked in the past because everyone knows about and has access to the data that we use but we would argue that because of the pain that it sometimes takes to stick with a strategy like this because it can be painful for three even five years sometimes of underperformance and because it’s not scalable for the asset management business which is a really important part of what drives stock returns overall that a strategy like this especially for individual investors but for smaller investors is a far better way of using factors overall this is the kind of portfolio you get so um this is a 55 stock portfolio it’s got a shareholder yield of 9.2% so almost more than almost four times that um five times that of the index at 2.1 you hear all this talk about BuyBacks but the index’s buyback yield is actually negative so when you account for all the share issuance that goes on at the same time there are basically no BuyBacks happening which is pretty interesting um very cheap right 12 times earnings one times sales six times iida uh a little more on pre cash flow but huge huge discounts to the market again if value works because people get too pessimistic the lower the valuation ratio the more pessimistic the better your expected future returns that is only achievable in a portfolio that looks very different that is very active relative to the S&P 500 that is not the direction the fund industry has gone so those kind of advantages have led to very interesting results um so uh I won’t even tell you what the names of these strategies are because I’m not trying to promote them and and and I don’t think most people could even ACC access them but these two strategies this is a small cap and a large cap version of what we’ve been doing for 15 plus years are the cumulative uh excess or just cumulative returns overall since 2004 which is when the small one launched so 240 to 263 we show them next to we call it smart beta but this is just the Russell um large and small style indexes so the major story has been growth outperforming value so those are growth those are value value when you put it in the lens of what can be achieved through a much more differentiated portfolio all of a sudden that whole story seems to go away they look very clustered like they’re all delivering kind of different versions of the same thing and I’ll close with an example that I’ve been using recently because I just think it’s the best way of illustrating this idea between whether or not a strategy is about actually earning alpha or whether it’s about Gathering assets for the sponsor of that strategy so the Russell 1000 value arguably one of the most popular value strategies out there one ETF alone has 25 ion Dollar in it the ey shares one largest stock in the Russell 1000 value is Exxon Mobile uh which is a popular Value stock look at a lot of large value managers you’ll see Exxon Mobile in there trading at low multiples of earnings uh which is kind of a garbage way of evaluating an energy stock to begin with u but still biggest stock in the S&P 500 it’s there because of its Price to Book which is the methodology behind the Russell 1000 value it’s only in the 50th percentile of all stocks in the Russell 1000 value by Price to Book so it is far the weight of stocks is far more determined by their size and the derivative of that is the assets which can be accommodated in strategies which charge management fees to invest in them um than is its Price to Book itself so if you believe in factors any exposure to the market cap Factor dilutes your advantage but that is where the world has gone because there’s an industry that sits on top of this um so I would urge you read that book by Manel BR and if you’re going to go into the equity World using factors do it in a way that is agnostic to the market don’t be a slave to the S&P 500 use factors to build a more differentiated portfolio because I would argue that’s the only way of having a sustainable Edge into the future thank [Applause] you you guys implemented this in a long short model as well to see what happens when you shortly expensive ones and go long yeah so uh yes um and we failed and and the reason is so you know you look at something like this and you think God perfect long short tool you know go long this stuff short that stuff two problems this stuff is exceptionally volatile s and often very just from a logistic standpoint operationally very expensive or impossible to borrow um so on the when you’re talking about shorts paper or back tests when it comes to shorts are is a dangerous game to play because when you go actually try to implement short sides of these factors in the real world um they can Beast you pretty quickly um that’s been our experience I think there are very good ways of doing this um it probably is in large cap where you start with the universe of easy or cheap to borrow stocks um and you do a lot of matching so I didn’t talk about like portfolio construction you know do you take industry bets how big of an industry bet are you willing to take are you willing to take oil bets there’s all sorts of risks that get baked into a portfolio a long short application of this idea I think needs to very smartly and wisely manage risk exposures um so you probably want to be neutral to Industry you probably want to be neutral to big risk variables um because those things can I mean think about you know energy as a as a good example if you were just long short value last year you got absolutely destroyed right because you got it two ways you were long you know Miners and and energy and stuff like that and you were short Facebook and Amazon and and those kinds of businesses you know David Einhorn who a guy I respect you know as much as any anyone out there um felt that pain a lot of big famous guys felt that pain if you’re agnostic to Industry and things like that you can get it both ways uh and that is not fun to live through and often client money will not stay with you through the times like that so we’ve tried it frankly we failed not to say we won’t succeed in the future uh but there are there are there are big hurdles to doing it right yeah hey have you had any experience with soft factors for example you know we have had situations where clients have come to us and say that uh find out the number of parking lots which is uh being filled by at at at at any Walmart store and uh you know more the parking lot probably B the stock so have you had any experience with with soft factors and how they sort of help us create that extra Alpha yeah so the question is experience with soft factors so um we think about this as like unstructured data or um you know just really unique things that might be specific to an individual company like how how full is a parking lot at Walmart or something like that um so the answer is yes and no um we’ve dealt a lot with things like sentiment and news data um where you use keywords and machine learning type stuff to try to find interesting factors we don’t use any so um we’ve looked we’ve yet to find something that is we think worthy of adding to our process I didn’t say this but one of the big important things with these strategies is not changing them too much because the Temptation is always to rotate into the hottest new thing there’s going to be an there has been and will continue to be an acceleration of the amount of papers being written on factors and the new one comes out and it’s better than the factor you bought a year ago and say well you know screw this I’m going to bail on that one to go into this one that kind of rotation is really dangerous because typically papers get written at the tail end of a mean reverting cycle so the Factor’s been doing really really well and then something structural you know people write papers about it and something structural changes or Tendencies change and it does really badly so a really important caveat to all this is there’s going to be stuff that comes out after you choose the strategy that’s going to test better than what you’ve got and you need to be very careful about making changes so when I say that we have an added it we have a super high bar for adding something into our process and nothing has yet met that bar yeah is this something you published on a paper um bits of it yeah I I I think um probably 75% of this is in various papers and posts and things like that so when you say it’s hard to that uh we could uh our our mandate is that we believe in Focus so we are all equities 100% um and have not delved into the option Market we’re we’re not a hch one right so it’s not we don’t have it just a wide open mandate we’re hired very specifically to do one thing um so that is certainly an option and a way around it um and this is on all stocks so there’s small caps in here and I don’t know enough about will be expensive hard to borrow stocks anyway because they’ll be pricing in the liquidity right VAR return return windows are an acor is process integration a lot of variations so the answer is way too long to give here um when I said that that one kind of simple back test I showed was high level I meant it every one of those factors has a lot of nuance um and each of these factors has different information Horizons so like momentum’s Horizon is very short you know 3 six months values is very long five sometimes 10 years and these different factors have different Horizons and that’s part of the pro that’s part of the management process um so I’ll stick around and we can talk a little bit more about it but but each one is nuanced yeah capacity clity um yeah we we do we already do it everywhere that you could do it um intern I guess we don’t do Frontier markets but we we do it in Emerging Markets we do it in international develop US Canada um we we are depends on the strategy you know either at at or near capacity or or not at all I mean our large cap strategy still has I don’t want I don’t want to sound like too much of a crusader here we still have we still have a lot of capacity because it’s large cap uh it’s all relative though it couldn’t couldn’t accommodate 30 billion uh which you know most large cap strategies probably could um so so we already do do it everywhere yeah yeah yeah well someday so I think we’re um out of time for this session if you guys have extra questions I’ll s around please feel free to go up and um and ask thanks guys thank you and girls