The 2-Century Investment Mystery
Why are there persistent free-lunch strategies?
A Common Practice
First and foremost, most investment researchers seek positive (or negative) conclusions. Confirming the null hypothesis does no good at all. The aim is either to be published or to arrive at a new investment scheme. Neither goal is achieved by learning that the factors are unrelated. What matters are results!
No surprise, then, that investment analysts are adept at discovering "anomalies"--investment oddities that can be discussed in a paper, used as an exchange-traded-fund strategy, or both. (If such anomalies did not exist, one might say, it would be necessary to invent them.) Analysts scour for data that support their views, but they tend to be much less diligent with disconfirming evidence.
This enterprizing mindset has its merits. It can identify temporary conditions. Its speculations lead to hypotheses that might otherwise go unexplored. And often, its findings are robust, to use the statistical lingo. For measuring powerful effects, such as the relationship between fund expenses and future returns, the back of the envelope works just as well as econometrics' calculations.
The Big Picture
There are times, however, when one desires something more complete: a study that might be faulted for using outmoded data, or for bludgeoning what could be caught with a butterfly net, but that will never be accused of being perfunctory. There is no need to test how its results perform out of sample, because there is no out of sample. The study encompasses all.
Such, with only modest exaggeration, is "Global Factor Premiums," or GFP, a Dutch collaboration between a university and asset manager. (Guido Baltussen and Laurens Swinkels of Erasmus University of Rotterdam and Robeco Asset Management; Pim van Vliet of Robeco.) As the authors note, most investment papers "start typically around 1980," often focusing "on a single asset class, typically U.S equities." Their ambitions are, to understate the matter, greater.
Specifically, they examine six potential investment factors, across 68 markets, for time periods that cans exceed 200 years. The markets consist of equities (for example, the United Kingdom, beginning in 1799); bonds (Norway 10-year, 1822); commodities (cocoa, 1979); and currencies (Australian dollar, as expressed in U.S. dollar terms, 1834).
(The study, it should be emphasized, evaluates markets and not individual securities. I initially made the mistake of thinking that the authors' assessment of "value" strategies for equities would emulate the well-known research by Eugene Fama and Ken French. Not so. Fama & French compare one stock against another. CVS Health (CVS) goes into the value bucket, while Amazon.com (AMZN) belongs in growth. GFP's authors compare countries. Italy is value, while the United States is growth.)
The paper offers the broadest of perspectives. It obscures most of the effects of time periods, countries, and asset classes. This is by no means unambiguously good. If a factor was strongly significant from 1850 to 1950 in European countries, for stocks, bonds, and currencies, but not commodities, and insignificant under every other situation, then it will likely appear as weakly significant overall. A steak that is charred on the outside and blue on the inside is not "medium."
(The authors, of course, recognize this issue and run various sensitivity tests. There are only so many nuances that they can uncover, though, in a study so expansive.)
But what a view! Here are the authors' six factors:
Building a Mystery
The upshot? Everything works! Not for all six factors, for all four asset classes, but the direction is uniform. Only seasonality has nonpositive results, for bonds and currency. (The authors state in the text that they did not test those two combinations, and yet their appendix carries the numbers…well, it's a working paper.) Of the 22 remaining combinations, 10 are statistically significant at the 1% level, and three others at the 5% level.
I cannot explain why these factors have been successful across the centuries, countries, and asset classes. Owning securities that have high carry scores, relatively low betas, or strong trend returns would not seem to be riskier than doing the reverse. (Never mind seasonality, which smacks of voodoo.) So why, over all those years and markets, should investors earn a premium for doing so?
The authors have no answer either. "We find no supporting evidence for (unified) explanations of the global factor returns based on market, downside, or macroeconomic risk…the global return factors bear basically no statistically or economically significant relation to common global macroeconomic factors."
In other words, the existing theories of investment behavior--which, to be sure, are plenty useful, being (for example) the underpinning for the development of market-index funds--are inadequate. That is an odd conclusion to derive for a subject that has been studied so extensively, for so long, but GFP does not make its case lightly.
John Rekenthaler has been researching the fund industry since 1988. He is now a columnist for Morningstar.com and a member of Morningstar's investment research department. John is quick to point out that while Morningstar typically agrees with the views of the Rekenthaler Report, his views are his own.
John Rekenthaler does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.