One line of attack against active investors is that they lack rigour: they easily succumb to behavioural biases and cling to past winners or losers far 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 be able to 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 that is not sufficient.
Enter the Godfather
Stephen Ross 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 held that a security’s price was driven by many factors, led him to be described as ‘the godfather of smart beta’ by Elroy Dimson of 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, say, is a useful factor with an associated risk premium, why should this be true? Is there some compelling economic argument supporting this? The overall market is obviously a concern for investors and the level of the yield curve is clearly a source of risk for bond portfolios, but why would momentum be a concern?
‘Is there some underlying significant risk it expresses? More to the point, is there a strong argument for why a momentum factor should contribute to a stock’s expected return? After decades of searching without compelling answers to such questions, we cannot be entirely comfortable that any empirical results are either valid or enduring.’
A hard case to argue
You can make a theoretical case against even the widely accepted factors, aside from Ross’s observations.
Cheap stocks should not outperform expensive ones because the market is efficient and so would not misprice assets to a statistically significant degree. Large companies should be superior to smaller ones because they should have established cash flows and resilient balance sheets. Dividend payers should lag those businesses that are still able to reinvest their profits for growth. And so on.
It is of course not very difficult to rebut these claims, but doing so can entail recognising that the market is not perfectly efficient. Champions of passive investing should therefore stop insisting that it is impossible to beat the market, and instead concentrate on explaining that 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,’ Ross concluded. ‘To do a satisfactory job, we will need theory as well as statistics; [they] can only take us so far toward identifying the factors and extracting them from return data.’
‘We now need to pay more attention to economics and somewhat less to constructing yet another combination of stock returns to try as a factor.’