The line of attack against active investors is they lack rigour, easily succumb to behavioural biases and cling to past winners or losers too long.
Passive investors, and especially those who employ factor-based strategies, regard themselves as rules-based and immune from these dangerous temptations.
Yet how many factor investors can clearly and compellingly articulate their rationale for holding a given factor? Plenty will point to past performance as evidence of a risk premium for their factor, but any critics of active management among their number will know that is not sufficient.
Enter the Godfather
Economist Stephen Ross (pictured) takes up the question in an essay in the latest edition of the Journal of Portfolio Management, which is devoted to factors. Ross, who died in March, cannot be dismissed as an advocate for the active industry.
His pioneering work on arbitrage pricing theory in the 1970s, which said a security’s price was driven by many factors, led him to be described as ‘the godfather of smart beta’ by Elroy Dimson, professor of finance at the London Business School.
Ross was particularly worried by ‘the lack of a strong economic foundation for many of the factor candidates.
‘Even if we accept statistical evidence that momentum is a useful factor with an associated risk premium, why should this be true?’ he wrote. ‘Is there some compelling economic argument supporting this? The overall market is a concern for investors and the level of the yield curve is a source of risk for bond portfolios, but why would momentum be a concern?
‘Is there some underlying significant risk it expresses? Is there a strong argument for why a momentum factor should contribute to a stock’s expected return? After decades of searching without finding compelling answers to such questions, we cannot be entirely comfortable any empirical results are either valid or enduring.’
Arguing the case
You can make a theoretical case against the widely accepted factors, aside from Ross’s observations. Cheap stocks should not outperform expensive ones, because the market is efficient so would not misprice assets to a statistically significant degree.
Large companies should be superior to smaller ones because they should have established cashflows and resilient balance sheets. Dividend payers should lag those businesses that can reinvest their profits for growth, and so on.
It is not difficult to rebut these claims, but doing so can entail recognising the market is not perfectly efficient. Champions of passive investing should therefore stop insisting it is impossible to beat the market, and instead concentrate on explaining it is hard for humans with their inherent biases to do so reliably.
‘We are still on this journey of identifying the factors driving stock returns,’ said Ross. ‘To do a satisfactory job, we will need theory as well as statistics. Stats can only take us so far towards identifying the factors and extracting them from return data.
‘We now need to pay more attention to economics and less to constructing another combination of stock returns to try as a factor.’