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Is It Science or Is It Baloney?

We try to distinguish good active strategies from flashes in the pan.

Morningstar, 12/20/2016

By Laurence B. Siegel1

Laurence B. Siegel is the Gary P. Brinson director of research at the CFA Institute Research Foundation.

Which currently popular investment strategies are flashes in the pan, and which are actually worthy innovations? Which are somewhere in between?

Because the theoretical or academic pedigree of an investment strategy helps mightily to sell it, marketers often represent whatever they’re selling as “real science,” with roots in the work of Nobel Prize-winning financial economists. Some of these claims are justified. Some are almost entirely hype. More often, they’re in between— good investment ideas that, sooner or later, take on the shape of fads and become crowded trades that lose their effectiveness.

Let’s look, through this lens, at some strategies that are receiving attention from investors. Before starting, I’ll state my biases: Indexing is usually a very good way for investors to obtain access to an asset class, because it is hard to pick successful active managers and active strategies— but active management is not useless.2Far from it! Many strategies, especially value strategies, have delivered superior returns over long periods of time. Given the behavioral biases and information asymmetries that we observe almost everywhere, value investing can be expected to continue to perform well on average over time (although not all the time!). The effort to distinguish good active strategies from doubtful ones is well worth one’s while.

Because most strategies start out as plausibly good ideas, at least in a backtest, and because no active strategy can “work” everywhere and always, most of the investment ideas covered in this article are in-betweeners. They are neither exact science nor pure baloney. But, as practiced and marketed, they sometimes lean to one side or the other.

For each strategy, several questions should be asked:

  • Is it grounded in real theory?
  • Is it scalable, that is, will it still work more often than not after it becomes popular? It is not necessarily bad to pursue a strategy that fails as more and more people attempt it, but at least you should know that a strategy has that characteristic, and you should have some indication of when to stop.
  • Does it work (have a reasonable prospect of producing alpha) after all transaction costs and reasonable fees have been subtracted?

Capitalization-Weighted Indexing
Cap-weighted indexing is the base case to which all active strategies must be compared. For a strategy to be considered active, it is necessary to define what is not active. A number of passive strategies can be imagined, including buy-and-hold-forever-without-rebalancing. But the only passive strategy—in fact, the only strategy of any kind—that everyone can follow without any stocks or bonds or other assets being “left over” is cap-weighted indexing. Cap-weighted indexing is macroconsistent.3

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