Wall Street Quants Shouldn't Confuse Luck With Skill

Johannes Kepler is remembered for his seminal contributions to astronomy. However, like most 16th-century astronomers, he supported himself in part by making astrological predictions. His mentor, Michael Mäestlin, taught him to always prophesy disaster. If something bad happens, you’re celebrated for being right. If not, you’re celebrated for preventing catastrophe. Making optimistic predictions either makes you look foolish if bad things happen or be forgotten if nothing bad happens.

Which brings us to February 2016, when Rob Arnott and his colleagues at investment firm Research Affiliates, or RA, published a paper titled “How Can ‘Smart Beta’ Go Horribly Wrong?” This month the team declared victory with “Revisiting Our ‘Horribly Wrong’ Paper: That Was Then, This Is Now.” For investors, “smart beta” means getting exposure to a market selectively rather than simply buying all assets in that market. Popular factors are size (buy stocks with small market capitalization), value (buy stocks with low ratios of price to value metrics like book value or cash flow) and momentum (buy assets that have gone up in price recently). The term “factor investing” is similar except managers also short assets with the opposite characteristics, such as buying stocks with small capitalization and shorting stocks with large capitalization.

The 2016 paper claimed that four specific factors - size, quality, momentum and low beta - had very low value characteristics relative to history. In other words, to get exposure to those factors you had to buy stocks with poor value characteristics, such as high price to book value ratios, and that in similar periods in the past those factors had underperformed. The impression given by the paper’s title and some of its rhetoric was that factors would crash in the near future, but the actual recommendations were more modest: investors should readjust expectations for lower factor returns from non-value factors and increase emphasis on value.