Why don't you factor tilt?

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Beensabu
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Re: Why don't you factor tilt?

Post by Beensabu »

rkhusky wrote: Tue Sep 20, 2022 6:12 pm
stan1 wrote: Tue Sep 20, 2022 4:47 pm
diversification - the action of diversifying something or the fact of becoming more diverse.
"growers should start planning diversification of crops"
I find definitions that use a form of the word to be defined not very helpful.
I like investopedia for investment-related terminology.
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.
Diversification is a risk management strategy that mixes a wide variety of investments within a portfolio.
Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.
The primary purpose of diversification is to mitigate risk. By spreading your investment across different asset classes, industries, or maturities, you are less likely to experience market shocks that impact every single one of your investments the same.
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Re: Why don't you factor tilt?

Post by LadyGeek »

Consider the definition in the wiki: Factors (finance)
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Re: Why don't you factor tilt?

Post by Apathizer »

Marseille07 wrote: Tue Sep 20, 2022 5:49 pm
Apathizer wrote: Tue Sep 20, 2022 5:35 pm Apparently I wasn't clear. I was comparing the total global market, including the US, to only the US. Vanguard compared them and found an allocation of about 30-40% ex-US has better risk adjusted returns than US only.

That said, the difference isn't so significant that US only are taking significantly more risk. Much as with factors, I think ex US markets provide some beneficial diversification, but it's probably not essential.
You weren't, but mixing more volatile assets (ex-US) into US does not reduce volatility.

I get what Vanguard is saying though. They're basically doing an efficient-frontier type stuff, where you might find some mix of lower volatility.

This is, of course, data dependent and subject to change. I don't question their study based on the data they used, but I question if their conclusion continues to materialize.
Though global market correlation has increased recently ex US markets are still imperfectly correlated and there's dispersion among different national markets. Again, the difference isn't so significant US only investors will probably be fine.
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Re: Why don't you factor tilt?

Post by rkhusky »

Beensabu wrote: Tue Sep 20, 2022 7:01 pm
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.
Sometimes Investopedia is good, sometimes not so much.

The wiki definition calls market beta a factor. So, does factor investing include a TSM-only portfolio? Hard to generate above market returns with TSM.
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Re: Why don't you factor tilt?

Post by Apathizer »

rkhusky wrote: Tue Sep 20, 2022 7:18 pm
Beensabu wrote: Tue Sep 20, 2022 7:01 pm
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.
Sometimes Investopedia is good, sometimes not so much.

The wiki definition calls market beta a factor. So, does factor investing include a TSM-only portfolio? Hard to generate above market returns with TSM.
It would seem impossible for something that is the market to generate higher returns than the market.
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Re: Why don't you factor tilt?

Post by TxFrog »

Why I don’t factor tilt:

1. The long term real expected risk premium over government bonds is greater than long term HmL or SmB premias. That is, the difference between the expected real return of global equities (GE) and the real rate of government bonds, (E(GE) – E(bonds)), is greater than the difference between factor tilted equities and the real return of GE, (E(factor tilt) – E(GE)). Or expressed below:

(E(GE) – E(bonds)) > (E(factor tilt) – E(GE))

For example, if the long term real expected returns of global equities is say 5% and the real expected returns of government bonds is 1%, then it is highly unlikely an equity factor tilt or any factor premium will offer you a premium of greater than 400 basis points (5% - 1%).

Because of this, if an investor wished to increase the real expected return of their portfolio in exchange for more volatility/risk, all that is needed is to increase the percentage of equities. For example, shift from a 80/20 portfolio to a 90/10 portfolio. Factor tilting the equity portion of the portfolio is unnecessary to achieve this goal.

2. There is low confidence that the long term real expected risk premium over government bonds is less than Hml or SmB premias. Or in other words, there is most likely a low probability (less than 50%) that equity factor risk premias (HmL, SmB, etc.) are greater than long term real expected risk premium over government bonds.

P((E(GE) – E(bonds)) < (E(factor tilt) – E(GE))) > 0.5

You can factor tilt, but you probably would have done better or just as good by increasing equity exposure.

I’m not anti-factor tilt, just neutral on topic and believe it’s not necessary for most investors.
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Re: Why don't you factor tilt?

Post by Beensabu »

rkhusky wrote: Tue Sep 20, 2022 7:18 pm
Beensabu wrote: Tue Sep 20, 2022 7:01 pm
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.
Sometimes Investopedia is good, sometimes not so much.

The wiki definition calls market beta a factor. So, does factor investing include a TSM-only portfolio? Hard to generate above market returns with TSM.
Beta is a factor. The beta of TSM/S&P 500 is 1. Beta is the only factor in CAPM, and it's one of the three factors in the three-factor model. The whole point of the three-factor model is that exposure to beta alone didn't explain the excess returns of some portfolios, so they went about trying to identify additional factors that explained the rest of it. At least, that's my understanding of the whole thing up until that point.

Edit: Okay, I just realized that isn't super helpful.

The beta of TSM/S&P 500 is 1.

The beta of short-term treasuries is pretty much 0.

The beta of a 50/50 TSM/short-term treasuries portfolio is 0.5.

As you increase beta, you increase risk. Since risk is related to return, increasing beta theoretically increases expected return.

I think what they found was that there were some portfolios that had the same beta as other portfolios but had also shown a higher return than those other portfolios with the same beta. Thus the trying to figure out why / what was different about those. And voila! Additional factors.
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Re: Why don't you factor tilt?

Post by Nathan Drake »

TxFrog wrote: Tue Sep 20, 2022 8:19 pm Why I don’t factor tilt:

Because of this, if an investor wished to increase the real expected return of their portfolio in exchange for more volatility/risk, all that is needed is to increase the percentage of equities. For example, shift from a 80/20 portfolio to a 90/10 portfolio. Factor tilting the equity portion of the portfolio is unnecessary to achieve this goal.
Increasing allocation to equities just increases your exposure to one factor.

There are times where the HmL premium is highly positive and the Mkt premium is negative.

I would rather add that diversified exposure in combination with an expected premium than just doubling down on one factor
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Re: Why don't you factor tilt?

Post by Apathizer »

Nathan Drake wrote: Tue Sep 20, 2022 10:30 pm
TxFrog wrote: Tue Sep 20, 2022 8:19 pm Why I don’t factor tilt:

Because of this, if an investor wished to increase the real expected return of their portfolio in exchange for more volatility/risk, all that is needed is to increase the percentage of equities. For example, shift from a 80/20 portfolio to a 90/10 portfolio. Factor tilting the equity portion of the portfolio is unnecessary to achieve this goal.
Increasing allocation to equities just increases your exposure to one factor.

There are times where the HmL premium is highly positive and the Mkt premium is negative.

I would rather add that diversified exposure in combination with an expected premium than just doubling down on one factor
Yeah, I've heard that argument too, but holding a factor diversified portfolio and bonds is more well diversified than only a TSM portfolio with few or no bonds.
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Re: Why don't you factor tilt?

Post by Marseille07 »

Apathizer wrote: Tue Sep 20, 2022 11:49 pm Yeah, I've heard that argument too, but holding a factor diversified portfolio and bonds is more well diversified than only a TSM portfolio with few or no bonds.
But you realize that diversification isn't the goal for everyone, right? Some folks purposely choose to have a not-so-diversified portfolio.

As I said somewhere upthread, it comes down to believing in American exceptionalism to some degree.
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Re: Why don't you factor tilt?

Post by Beensabu »

My last quoting of investopedia on this thread (probably), from "What Is Diversification? Definition as Investing Strategy":
For investors wanting to maximize their returns, diversification may not be the best strategy. Consider "YOLO" (you only live once) strategies where 100% of capital is placed in a high-risk investment. Though there is the higher probably of making life-changing money, there is also the highest probability of losing capital due to poor diversification.
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Re: Why don't you factor tilt?

Post by Apathizer »

Marseille07 wrote: Tue Sep 20, 2022 11:53 pm
Apathizer wrote: Tue Sep 20, 2022 11:49 pm Yeah, I've heard that argument too, but holding a factor diversified portfolio and bonds is more well diversified than only a TSM portfolio with few or no bonds.
But you realize that diversification isn't the goal for everyone, right? Some folks purposely choose to have a not-so-diversified portfolio.

As I said somewhere upthread, it comes down to believing in American exceptionalism to some degree.
I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
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Re: Why don't you factor tilt?

Post by acegolfer »

rkhusky wrote: Tue Sep 20, 2022 7:18 pm
Beensabu wrote: Tue Sep 20, 2022 7:01 pm
Factor investing, from a theoretical standpoint, is designed to enhance diversification, generate above-market returns and manage risk.
Sometimes Investopedia is good, sometimes not so much.

The wiki definition calls market beta a factor. So, does factor investing include a TSM-only portfolio? Hard to generate above market returns with TSM.
Clarification: The market portfolio is a factor. otoh, market beta is the factor loading (= regression coefficient).
Technically, TSM is a factor investing. However, most ppl won't call it factor investing.
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Re: Why don't you factor tilt?

Post by Robert T »

LadyGeek wrote: Tue Sep 20, 2022 7:13 am I should note that Robert T is the OP for the forum sticky topic Collective thoughts [investing mini-reference].

Robert T - If you think it's appropriate, consider adding that content to your forum thread.
.
Thank you LadyGeek. I also need to do some other updates that I will try to do, perhaps more completely, at the end of the year.

This paper on Assessing the Relative Magnitude of Premiums (particularly Exhibit 1) may also be relevant for the discussion on factor tilts (or not) in US vs. non-US markets. Obviously no guarantees.
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Re: Why don't you factor tilt?

Post by rkhusky »

Beensabu wrote: Tue Sep 20, 2022 10:15 pm As you increase beta, you increase risk. Since risk is related to return, increasing beta theoretically increases expected return.
That's not true in general. Gambling at a casino is high risk, but the expected return is negative. With gambling, one should at least make sure that the potential for higher return increases when higher risk is taken.

With investing, you should make sure, as much as possible, that your expected return increases when you take higher risk.
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Re: Why don't you factor tilt?

Post by acegolfer »

rkhusky wrote: Wed Sep 21, 2022 7:19 am
Beensabu wrote: Tue Sep 20, 2022 10:15 pm As you increase beta, you increase risk. Since risk is related to return, increasing beta theoretically increases expected return.
That's not true in general. Gambling at a casino is high risk, but the expected return is negative. With gambling, one should at least make sure that the potential for higher return increases when higher risk is taken.

Rather, investors should make sure, as much as possible, that their expected return increases when they take higher risk.
imo, Gambling is not a good example. The difference is in the case of stocks (unlike gambling), the factor expected return is positive. So higher factor loading, higher expected return.
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Re: Why don't you factor tilt?

Post by afan »

Da5id wrote: Tue Sep 20, 2022 3:14 pm
There are optimal answers based on past data. Whether those carry forward into the future...
Exactly. Are we drawing from a stationary distribution? That is, absent noise, do we expect the relative performance that was observed over some time period to be the, unchanging, central tendency? If so, which is the time period that best captures the true relationship? If the true underlying, unobservable, relative performance can change, then how do we whether it has? With the noise in stock returns, it could take a lifetime of data to know.
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Re: Why don't you factor tilt?

Post by rkhusky »

acegolfer wrote: Wed Sep 21, 2022 7:21 am
rkhusky wrote: Wed Sep 21, 2022 7:19 am
Beensabu wrote: Tue Sep 20, 2022 10:15 pm As you increase beta, you increase risk. Since risk is related to return, increasing beta theoretically increases expected return.
That's not true in general. Gambling at a casino is high risk, but the expected return is negative. With gambling, one should at least make sure that the potential for higher return increases when higher risk is taken.

Rather, investors should make sure, as much as possible, that their expected return increases when they take higher risk.
imo, Gambling is not a good example. The difference is in the case of stocks (unlike gambling), the factor expected return is positive. So higher factor loading, higher expected return.
You can't compute the expected return for stocks because you don't know the future probability distribution.
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Re: Why don't you factor tilt?

Post by mikejuss »

Because it's too painful.
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Re: Why don't you factor tilt?

Post by acegolfer »

rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
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Re: Why don't you factor tilt?

Post by rkhusky »

acegolfer wrote: Wed Sep 21, 2022 7:41 am
rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks, which is what is required for factor estimations, is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
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Re: Why don't you factor tilt?

Post by acegolfer »

rkhusky wrote: Wed Sep 21, 2022 7:47 am
acegolfer wrote: Wed Sep 21, 2022 7:41 am
rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
We were talking about beta. No need to estimate difference.
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Re: Why don't you factor tilt?

Post by rkhusky »

acegolfer wrote: Wed Sep 21, 2022 7:49 am
rkhusky wrote: Wed Sep 21, 2022 7:47 am
acegolfer wrote: Wed Sep 21, 2022 7:41 am
rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
We were talking about beta. No need to estimate difference.
To estimate expected return in a factor model, you need to estimate differences.
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Re: Why don't you factor tilt?

Post by homebuyer6426 »

I don't factor tilt because I sector tilt. After looking at more than 50 years of sector average returns and volatility data. Time will tell if it pays off, but if it doesn't, I'll still be okay.
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Re: Why don't you factor tilt?

Post by Random Walker »

rkhusky wrote: Wed Sep 21, 2022 8:15 am
acegolfer wrote: Wed Sep 21, 2022 7:49 am
rkhusky wrote: Wed Sep 21, 2022 7:47 am
acegolfer wrote: Wed Sep 21, 2022 7:41 am
rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
We were talking about beta. No need to estimate difference.
To estimate expected return in a factor model, you need to estimate differences.
True. I believe though, that one can and should be very rough and conservative in the estimates when guesstimating the factor premia. I believe this is pretty dicey territory since, in an effort to build a more efficient portfolio with a move towards risk parity, one most likely decreases overall equity allocation as he tilts the equities.

Dave
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Re: Why don't you factor tilt?

Post by rkhusky »

Random Walker wrote: Wed Sep 21, 2022 8:56 am
rkhusky wrote: Wed Sep 21, 2022 8:15 am
acegolfer wrote: Wed Sep 21, 2022 7:49 am
rkhusky wrote: Wed Sep 21, 2022 7:47 am
acegolfer wrote: Wed Sep 21, 2022 7:41 am

Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
We were talking about beta. No need to estimate difference.
To estimate expected return in a factor model, you need to estimate differences.
True. I believe though, that one can and should be very rough and conservative in the estimates when guesstimating the factor premia. I believe this is pretty dicey territory since, in an effort to build a more efficient portfolio with a move towards risk parity, one most likely decreases overall equity allocation as he tilts the equities.

Dave
The problem is that you often can't tell if the premia will be positive or negative. I suppose if you can cap the absolute magnitude, you can get a feeling for how far from the market you might end up, either below or above.
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Re: Why don't you factor tilt?

Post by Marseille07 »

Apathizer wrote: Wed Sep 21, 2022 3:57 am I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
Isn't it considered...timing?

If we go by the US vs ex-US dichotomy, I think the only options are:
a) US-only
b) World market-cap weight (VT or you DIY VTI & VXUS)
c) up to 20% ex-US, the rest in US because Bogle said so

Tilting EM doesn't really come into the picture here imo.
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Re: Why don't you factor tilt?

Post by Da5id »

Marseille07 wrote: Wed Sep 21, 2022 9:47 am
Apathizer wrote: Wed Sep 21, 2022 3:57 am I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
Isn't it considered...timing?

If we go by the US vs ex-US dichotomy, I think the only options are:
a) US-only
b) World market-cap weight (VT or you DIY VTI & VXUS)
c) up to 20% ex-US, the rest in US because Bogle said so
Interesting you think those are the "only options". Some people invest between 20% and market cap. At least one who posts owns more than market cap weight of ex-US. Those appear to be "options".
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Re: Why don't you factor tilt?

Post by Marseille07 »

Da5id wrote: Wed Sep 21, 2022 9:54 am
Marseille07 wrote: Wed Sep 21, 2022 9:47 am
Apathizer wrote: Wed Sep 21, 2022 3:57 am I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
Isn't it considered...timing?

If we go by the US vs ex-US dichotomy, I think the only options are:
a) US-only
b) World market-cap weight (VT or you DIY VTI & VXUS)
c) up to 20% ex-US, the rest in US because Bogle said so
Interesting you think those are the "only options". Some people invest between 20% and market cap. Some who post own more than market cap. Those appear to be "options".
What's your rationalization to go between 20~the market cap or to go above?
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Re: Why don't you factor tilt?

Post by Da5id »

Marseille07 wrote: Wed Sep 21, 2022 9:58 am
Da5id wrote: Wed Sep 21, 2022 9:54 am
Marseille07 wrote: Wed Sep 21, 2022 9:47 am
Apathizer wrote: Wed Sep 21, 2022 3:57 am I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
Isn't it considered...timing?

If we go by the US vs ex-US dichotomy, I think the only options are:
a) US-only
b) World market-cap weight (VT or you DIY VTI & VXUS)
c) up to 20% ex-US, the rest in US because Bogle said so
Interesting you think those are the "only options". Some people invest between 20% and market cap. Some who post own more than market cap. Those appear to be "options".
What's your rationalization to go between 20~the market cap or to go above?
The word "rationalization" rather than "rationale" here seems very judgmental to me. Are you intending that?

Looking at figure 3 in https://corporate.vanguard.com/content/ ... Online.pdf between 20 and 40% is all reasonable IMO. https://www.bogleheads.org/blog/2020/03 ... ld-part-1/ makes a case for some home country bias, which can put you between VT and 20%. I don't think it is any less rational a choice than any other.

I own 40% international. But I think 30% ex-US is "an option" and is perfectly reasonable. As is 50% ex-US.
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Re: Why don't you factor tilt?

Post by acegolfer »

Marseille07 wrote: Wed Sep 21, 2022 9:58 am What's your rationalization to go between 20~the market cap or to go above?
Do you realize that US TBM is about the same size as US TSM? Nevertheless, most don't use 50/50 AA. Why? Because we treat them as different asset classes. As long as one consider Int'l stocks as a separate asset class from domestic stocks, it's justifiable to have different AA from market weights.
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Re: Why don't you factor tilt?

Post by JackoC »

rkhusky wrote: Wed Sep 21, 2022 7:47 am
acegolfer wrote: Wed Sep 21, 2022 7:41 am
rkhusky wrote: Wed Sep 21, 2022 7:30 am You can't compute the expected return for stocks because you don't know the future probability distribution.
Correct. But we can estimate expected return and it's likely positive.
But estimating the difference in return of various categories of stocks, which is what is required for factor estimations, is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
I agree and that goes for non-US stocks also. Often on the forum people take the position that they make no assumption about future returns. This is untenable, though I guess mainly they don't really understand they are making an assumption rather than consciously dissembling. Usually the assumption is that the expected return (only correct definition in this context is something like 'centroid of the future distribution of returns') 'in the long run' is equal to the past average return, an assumption with little basis IMO in general and a clearly optimistic one now. But the frustrating part is not disagreement about the assumption but rather people insisting they are making no assumption about future returns when in fact they are, and one must make *some* assumption and rely on it to *some* degree.

But I agree with you when it comes to 'factor tilt' particularly it tends to rely more heavily on estimating the difference in expected return (for risk) between/among factors and that's harder than a general estimate of expected return for the market. Non-US IMO can easily be justified with a diversification argument. Some also believe the expected return of ex-US is higher but that belief isn't as key.
Last edited by JackoC on Wed Sep 21, 2022 10:50 am, edited 1 time in total.
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Re: Why don't you factor tilt?

Post by Marseille07 »

Da5id wrote: Wed Sep 21, 2022 10:12 am The word "rationalization" rather than "rationale" here seems very judgmental to me. Are you intending that?

Looking at figure 3 in https://corporate.vanguard.com/content/ ... Online.pdf between 20 and 40% is all reasonable IMO. https://www.bogleheads.org/blog/2020/03 ... ld-part-1/ makes a case for some home country bias, which can put you between VT and 20%. I don't think it is any less rational a choice than any other.

I own 40% international. But I think 30% ex-US is "an option" and is perfectly reasonable. As is 50% ex-US.
I think that's fair. So let's call it 0%~MCW (40% or so currently iirc)?
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Re: Why don't you factor tilt?

Post by Chief_Engineer »

Marseille07 wrote: Wed Sep 21, 2022 9:58 am What's your rationalization to go between 20~the market cap or to go above?
My rationale comes from this series by Siamond. It appears to make sense to have a bit of a home country bias. I don't know if it is "optimal" but it allowed me to make a decision and stick with it.
Apathizer
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Re: Why don't you factor tilt?

Post by Apathizer »

Marseille07 wrote: Wed Sep 21, 2022 9:47 am
Apathizer wrote: Wed Sep 21, 2022 3:57 am I try to be pragmatic rather than ideological. If I could only invest in one country it would be the US. I think there's a good chance the US will continue to out-perform ex-US, but I'm not so confident as to dismiss ex-US entirely. I think emerging markets have both tremendous potential and risk, so I want some exposure but not too much.
Isn't it considered...timing?

If we go by the US vs ex-US dichotomy, I think the only options are:
a) US-only
b) World market-cap weight (VT or you DIY VTI & VXUS)
c) up to 20% ex-US, the rest in US because Bogle said so

Tilting EM doesn't really come into the picture here imo.
I go with about 40% ex-US since that's about global market cap and makes re-balancing simple. DFAX maintains global market cap weighting for both developed (about 2/3) and emerging market (1/3) ex-US. This seems reasonable. It's essentially a factor-slanted version of VXUS.
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abc132
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Re: Why don't you factor tilt?

Post by abc132 »

JackoC wrote: Wed Sep 21, 2022 10:48 am .. when it comes to 'factor tilt' particularly it tends to rely more heavily on estimating the difference in expected return (for risk) between/among factors and that's harder than a general estimate of expected return for the market. Non-US IMO can easily be justified with a diversification argument. Some also believe the expected return of ex-US is higher but that belief isn't as key.
Looking at how the expected stock CAPE returns compared to actual returns, they have shown fairly poor future predictability. Taking even less certain estimations for factors, we should expect future predictability from the models to be less than what CAPE has done. I suppose we can always say that analyzing data after the fact is predictive (it's not), but that can't ever earn us any actual returns or premiums. Given the uncertainty in realized returns from market expectations, we should expect these factor models to be poor at predicting future performance and premiums if they have significantly less certainty than market/beta predictions.

The models rely on factors being independent sources of risk, which they are not. A large solar flare, a war, a pandemic - any black swan event can do completely opposite things to any given factor depending on the specifics of the black swan. If/when the market doesn't hold up in a manner big enough that we need diversification beyond fixed income, we can't say what factors will do.

Factors are a little bit of spice you add to your food. In the right combination they may end up helping, but they are not going to sustain you when you can't find enough food. Nobody should be so concerned that 85% of their taste is from their food that they stock up on gallons and gallons of spices, nor should they be telling everyone else they are going to starve without spices. In a similar manner, the stock market is what will either sustain or not sustain us investors who are willing to put out money at risk. Factors are just the flavor of the decade, and this too will pass.
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Re: Why don't you factor tilt?

Post by JackoC »

abc132 wrote: Wed Sep 21, 2022 11:34 am
JackoC wrote: Wed Sep 21, 2022 10:48 am .. when it comes to 'factor tilt' particularly it tends to rely more heavily on estimating the difference in expected return (for risk) between/among factors and that's harder than a general estimate of expected return for the market. Non-US IMO can easily be justified with a diversification argument. Some also believe the expected return of ex-US is higher but that belief isn't as key.
Looking at how the expected stock CAPE returns compared to actual returns, they have shown fairly poor future predictability. Taking even less certain estimations for factors, we should expect future predictability from the models to be less than what CAPE has done. I suppose we can always say that analyzing data after the fact is predictive (it's not), but that can't ever earn us any actual returns or premiums. Given the uncertainty in realized returns from market expectations, we should expect these factor models to be poor at predicting future performance and premiums if they have significantly less certainty than market/beta predictions.

The models rely on factors being independent sources of risk, which they are not. A large solar flare, a war, a pandemic - any black swan event can do completely opposite things to any given factor depending on the specifics of the black swan. If/when the market doesn't hold up in a manner big enough that we need diversification beyond fixed income, we can't say what factors will do.
This is basically going around in the usual circle on this question. We are trying to estimate the *expected return*, not predict the realized return. If anyone could come up with a measure which closely predicted the realized return, it would prove that the asset in question had no risk, which we know it does. So we can't ever expect an estimate of the expected return of a risk asset to correlate very highly with the subsequent realized return. The issue is whether the estimate has a fundamental basis and whether it can be shown biased high or low, or else it should be accepted. 'CAPE' is so confused now with regressions attempting to show that higher valuation now correlates with lower valuation later, different issue, it should probably be left out for clarity. Although the derivation which says E[r, real]=1/PE is fundamental, it's not an empirical result. But again let's put CAPE aside and just take another fundamental formula for stock expected return E[r]=div yield+real div growth. Realized return can be higher/lower than that estimate because either a) 'div yield' isn't what it seems* b) we misestimate *expected* real div growth (Ilmanen estimated it as the past 100 yr average of real EPS growth, 1.5%, what's your different assumption?) or c) there is a speculative return over the given period...which there always will be, positive or negative. But to invalidate that equation you can't just say 'there could be solar flares' which we all know. You have to show why it's a *biased estimate of the midpoint* and in which direction, by coming up with different estimates for a) and b) or arguing why c) the *expected* speculative return, has a non-zero value (back to CAPE regressions, some would argue the expected value of the speculative return now is negative because CAPE is so high, but that's not a necessary assumption, E[r]=div yield+real div growth with no 3rd term implicitly assumes expected speculative return=0).

This sort of analysis leads to a relatively contained range of plausible expected return estimates (with which 1/CAPE pretty closely agrees right now). It makes clear the assumption 'expected return is past long run avg return' is biased to the optimistic side with valuations as high as now. Again not because valuation has to go down, but by basic fundamentals of less earnings/div you get for each $ invested. However again, to make such estimates for factors and say firmly which factor has higher expected return than another is more difficult. Too difficult IMO to really believe in factor investing, you should really believe in it to do it (so you don't just quit when 'it doesn't work for you') and that's a big reason I don't.

*as in 'how about buybacks?' but see Ilmanen on this, little convincing evidence net anti-dilutive buybacks are significant, US companies buy back more stock now than they used to but mainly when things are going well, they dilute more all the time than they used to. Especially if we define the asset class as global stocks which we probably should on a theoretical basis, and if people want to tilt toward/away from US within that, fine.
Last edited by JackoC on Wed Sep 21, 2022 12:12 pm, edited 1 time in total.
dbr
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Re: Why don't you factor tilt?

Post by dbr »

JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
Apathizer
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Re: Why don't you factor tilt?

Post by Apathizer »

abc132 wrote: Wed Sep 21, 2022 11:34 am The models rely on factors being independent sources of risk, which they are not. A large solar flare, a war, a pandemic - any black swan event can do completely opposite things to any given factor depending on the specifics of the black swan. If/when the market doesn't hold up in a manner big enough that we need diversification beyond fixed income, we can't say what factors will do.
They might not be entirely, but are at least somewhat independent, so provide some diversification benefits.

Consider recent history. The 2020 Covid lockdowns benefited large growth since most people were stuck at home and online. Over the last two years inflation and supply chain issues have benefit oil and other value market segments while growth has suffered disproportionately.

Not all crisises affect all market segments equally. Factor slants help protect against the potential for a significant drop in the large growth segment.
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abc132
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Re: Why don't you factor tilt?

Post by abc132 »

JackoC wrote: Wed Sep 21, 2022 12:04 pm
abc132 wrote: Wed Sep 21, 2022 11:34 am
JackoC wrote: Wed Sep 21, 2022 10:48 am .. when it comes to 'factor tilt' particularly it tends to rely more heavily on estimating the difference in expected return (for risk) between/among factors and that's harder than a general estimate of expected return for the market. Non-US IMO can easily be justified with a diversification argument. Some also believe the expected return of ex-US is higher but that belief isn't as key.
Looking at how the expected stock CAPE returns compared to actual returns, they have shown fairly poor future predictability. Taking even less certain estimations for factors, we should expect future predictability from the models to be less than what CAPE has done. I suppose we can always say that analyzing data after the fact is predictive (it's not), but that can't ever earn us any actual returns or premiums. Given the uncertainty in realized returns from market expectations, we should expect these factor models to be poor at predicting future performance and premiums if they have significantly less certainty than market/beta predictions.

The models rely on factors being independent sources of risk, which they are not. A large solar flare, a war, a pandemic - any black swan event can do completely opposite things to any given factor depending on the specifics of the black swan. If/when the market doesn't hold up in a manner big enough that we need diversification beyond fixed income, we can't say what factors will do.
This is basically going around in the usual circle on this question. We are trying to estimate the *expected return*, not predict the realized return. If anyone could come up with a measure which closely predicted the realized return, it would prove that the asset in question had no risk, which we know it does. So we can't ever expect an estimate of the expected return of a risk asset to correlate very highly with the subsequent realized return. The issue is whether the estimate has a fundamental basis and whether it can be shown biased high or low, or else it should be accepted. 'CAPE' is so confused now with regressions attempting to show that higher valuation now correlates with lower valuation later, different issue, it should probably be left out for clarity. Although the derivation which says E[r, real]=1/PE is fundamental, it's not an empirical result. But again let's put CAPE aside and just take another fundamental formula for stock expected return E[r]=div yield+real div growth. Realized return can be higher/lower than that estimate because either a) 'div yield' isn't what it seems* b) we misestimate *expected* real div growth (Ilmanen estimated it as the past 100 yr average of real EPS growth, 1.5%, what's your different assumption?) or c) there is a speculative return over the given period...which there always will be, positive or negative. But to invalidate that equation you can't just say 'there could be solar flares' which we all know. You have to show why it's a *biased estimate of the midpoint* and in which direction, by coming up with different estimates for a) and b) or arguing why c) the *expected* speculative return, has a non-zero value (back to CAPE regressions, some would argue the expected value of the speculative return now is negative because CAPE is so high, but that's not a necessary assumption, E[r]=div yield+real div growth with no 3rd term implicitly assumes expected speculative return=0).

This sort of analysis leads to a relatively contained range of plausible expected return estimates (with which 1/CAPE pretty closely agrees right now). It makes clear the assumption 'expected return is past long run avg return' is biased to the optimistic side with valuations as high as now. Again not because valuation has to go down, but by basic fundamentals or less earnings/div you get for each $ invested. However again, to make such estimates for factors and say firmly which factor has higher expected return than another is more difficult. Too difficult IMO to really believe in factor investing, you should really believe in it to do it (so you don't just quit when 'it doesn't work for you') and that's a big reason I don't.

*as in 'how about buybacks?' but see Ilmanen on this, little convincing evidence net anti-dilutive buybacks are significant, US companies buy back more stock now than they used to but mainly when things are going well, they dilute more all the time than they used to. Especially if we define the asset class as global stocks which we probably should on a theoretical basis, and if people want to tilt toward/away from US within that, fine.
I can't tell you in which direction factors are biased because they are not a fundamental property - that is any factor will have the opposite of it's expected direction/performance at some point in time. Nor do I need to do so to say the estimates being given are not very predictive or reliable. There is a phenomenon known as the butterfly effect that clearly demonstrates that some things about the future are not known. This is well-understood in the scientific community where we can back-test simulations to see what might have happened in the past, how galaxy's might form, etc, but this community recognizes the limitations of future predictions for complex systems. Things that are not currently even measurable are likely to change the end/future result.

In no way does anyone need to make more accurate future predictions to reject models that have been demonstrated to have low future predictability. You can't take "average annual stock performance" as the measure of regression for a system that compounds error over 20-50 years of investing. You are not even predicting a final result (portfolio size) within a factor of 2 over a 20 year period and are not looking at the actual error of the prediction. It has got to be a joke to say annual returns were within +/-5% annually over some 10-20 year period. That compounded error is so big as to have made the prediction not meaningful or useful.

I can say that human population is likely to increase and technology is likely to increase production per energy usage. All of these things should benefit the companies of the future and contribute to more earnings per dollar invested. That is the reason the market as a whole is very likely to hold up.
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Re: Why don't you factor tilt?

Post by JackoC »

abc132 wrote: Wed Sep 21, 2022 12:26 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
abc132 wrote: Wed Sep 21, 2022 11:34 am
JackoC wrote: Wed Sep 21, 2022 10:48 am .. when it comes to 'factor tilt' particularly it tends to rely more heavily on estimating the difference in expected return (for risk) between/among factors and that's harder than a general estimate of expected return for the market. Non-US IMO can easily be justified with a diversification argument. Some also believe the expected return of ex-US is higher but that belief isn't as key.
Looking at how the expected stock CAPE returns compared to actual returns, they have shown fairly poor future predictability. Taking even less certain estimations for factors, we should expect future predictability from the models to be less than what CAPE has done. I suppose we can always say that analyzing data after the fact is predictive (it's not), but that can't ever earn us any actual returns or premiums. Given the uncertainty in realized returns from market expectations, we should expect these factor models to be poor at predicting future performance and premiums if they have significantly less certainty than market/beta predictions.

The models rely on factors being independent sources of risk, which they are not. A large solar flare, a war, a pandemic - any black swan event can do completely opposite things to any given factor depending on the specifics of the black swan. If/when the market doesn't hold up in a manner big enough that we need diversification beyond fixed income, we can't say what factors will do.
This is basically going around in the usual circle on this question. We are trying to estimate the *expected return*, not predict the realized return. If anyone could come up with a measure which closely predicted the realized return, it would prove that the asset in question had no risk, which we know it does. So we can't ever expect an estimate of the expected return of a risk asset to correlate very highly with the subsequent realized return. The issue is whether the estimate has a fundamental basis and whether it can be shown biased high or low, or else it should be accepted. 'CAPE' is so confused now with regressions attempting to show that higher valuation now correlates with lower valuation later, different issue, it should probably be left out for clarity. Although the derivation which says E[r, real]=1/PE is fundamental, it's not an empirical result. But again let's put CAPE aside and just take another fundamental formula for stock expected return E[r]=div yield+real div growth. Realized return can be higher/lower than that estimate because either a) 'div yield' isn't what it seems* b) we misestimate *expected* real div growth (Ilmanen estimated it as the past 100 yr average of real EPS growth, 1.5%, what's your different assumption?) or c) there is a speculative return over the given period...which there always will be, positive or negative. But to invalidate that equation you can't just say 'there could be solar flares' which we all know. You have to show why it's a *biased estimate of the midpoint* and in which direction, by coming up with different estimates for a) and b) or arguing why c) the *expected* speculative return, has a non-zero value (back to CAPE regressions, some would argue the expected value of the speculative return now is negative because CAPE is so high, but that's not a necessary assumption, E[r]=div yield+real div growth with no 3rd term implicitly assumes expected speculative return=0).

This sort of analysis leads to a relatively contained range of plausible expected return estimates (with which 1/CAPE pretty closely agrees right now). It makes clear the assumption 'expected return is past long run avg return' is biased to the optimistic side with valuations as high as now. Again not because valuation has to go down, but by basic fundamentals or less earnings/div you get for each $ invested. However again, to make such estimates for factors and say firmly which factor has higher expected return than another is more difficult. Too difficult IMO to really believe in factor investing, you should really believe in it to do it (so you don't just quit when 'it doesn't work for you') and that's a big reason I don't.

*as in 'how about buybacks?' but see Ilmanen on this, little convincing evidence net anti-dilutive buybacks are significant, US companies buy back more stock now than they used to but mainly when things are going well, they dilute more all the time than they used to. Especially if we define the asset class as global stocks which we probably should on a theoretical basis, and if people want to tilt toward/away from US within that, fine.
I can't tell you in which direction factors are biased because they are not a fundamental property - that is any factor will have the opposite of it's expected direction/performance at some point in time. Nor do I need to do so to say the estimates being given are not very predictive or reliable. There is a phenomenon known as the butterfly effect that clearly demonstrates that some things about the future are not known. This is well-understood in the scientific community where we can back-test simulations to see what might have happened in the past, how galaxy's might form, etc, but this community recognizes the limitations of future predictions for complex systems. Things that are not currently even measurable are likely to change the end/future result.

In no way does anyone need to make more accurate future predictions to reject models that have been demonstrated to have low future predictability. You can't take "average annual stock performance" as the measure of regression for a system that compounds error over 20-50 years of investing. You are not even predicting a final result (portfolio size) within a factor of 2 over a 20 year period and are not looking at the actual error of the prediction.

I can say that human population is likely to increase and technology is likely to increase production per energy usage. All of these things should benefit the companies of the future and contribute to more earnings per dollar invested. That is the reason the market as a whole is very likely to hold up.
Your misconception is more basic than factors as in 'factor investing' so I'll reiterate based on the more basic idea of estimating expected return. The estimate of expected return cannot be validly discarded because the past estimate of ex ante expected return did not period after period fall right on top of the subsequent ex post realized return. To ask the estimate to do that, for a risk asset, must be to basically misunderstand what expected return means.

And in actual practice as was covered ad nauseum in the recent thread on Ilmanen's recent book, as well as various other threads, it's easy to see that in general the range of both realized returns and ex ante expected return of 60/40 by simple fundamental measures, div yield+avg past EPS growth and nominal bond yield minus survey based inflation expectation respectively, were in the same ballpark for nearly 1900-1990, then expected returns steadily dropped to levels never seen in the previous period but realized returns did not as valuations marched basically monotonically higher since around 1990. There is IOW no obvious evidence from the past that either of those fundamental measures, E[r, real, stock]=div yield+long term past avg real EPS growth or E[r, real, nominal bond]=yield-expected inflation is a biased estimate. And you do in fact have to show that to reject them. You can't just say 'I' don't know': you can't make any decisions about investing without any assumptions about future returns except in the most extreme boundary case. 'There will be innovation and the market will hold up' is some kind of assumption, and not at odds with E[r]=2.4% div+1.5% EPS growth, (VT's div yield, assume world growth trend around 3% real, US EPS growth in 20 th century was 1.5% less than GDP growth), as wishy washy qualitative statements are generally unlikely to be at odds with specific numerical estimates. But one must make some assumption to choose how much to invest, the exceptions to which would tend to just prove the rule. And 3.9% is very significantly lower than the assumption 'expected return=past avg return', so it's important.

OTOH this risk asset/factor has higher expected return than that one, more difficult, especially for things which give no direct read on expected return. The whole stock market does partly (in the div yield though requires us to assess if expected EPS growth is higher/lower than past long run, here I'm assuming same), bonds do pretty completely (no better estimate than the yield to the investing horizon), the 'SCV factor' doesn't at all, it's basically only derived from past return history. That's the difference I see, if ever we could get past the basic confusion about estimating expected return vs predicting realized return. :happy
Last edited by JackoC on Wed Sep 21, 2022 12:56 pm, edited 1 time in total.
Marseille07
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Re: Why don't you factor tilt?

Post by Marseille07 »

dbr wrote: Wed Sep 21, 2022 12:10 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
There is no such thing as the expected return, not anything you can derive by looking at (CA)PE, anyway.
JackoC
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Re: Why don't you factor tilt?

Post by JackoC »

Marseille07 wrote: Wed Sep 21, 2022 12:52 pm
dbr wrote: Wed Sep 21, 2022 12:10 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
1. There is no such thing as the expected return,
2. not anything you can derive by looking at (CA)PE, anyway.
1. A bold statement but not only untrue but basically self-refuting if we go through step by step how anyone is constructing an investment plan except pretty extreme exceptions which would just prove the rule. 'Future stock returns could be equally likely to exceed or fall short of 20% pa or equally like to exceed or fall short of -20% pa, and that would make no difference in how I approached investing, because I don't know the future'. That's the implication of 'no such thing as the expected return'.
2. The relationship of 'CAPE' to expected return is so confused it's harder to interpret what this is supposed to mean. But expected return is definitely connected to PE:
Price of a stock can be represented as S=Div/(r-g) S the stock price, r the return, and g the dividend growth rate, or IOW r=S/Div+g, the return the perpetual payout of the dividend plus dividend growth. But dividend growth comes from earnings growth comes from return. Assume in equilibrium the real expected return on the stock (index) is the return on capital of the company (ies in the index). So restate the first equation as S= p*E/(r-(1-p)*r), where p is the payout ratio, ie Div=p*E, div growth rate is (1-p)*r. Therefore r=E/S.

It's up to anyone refuting that to show why in practice the inherent simplifications bias the answer consistently in one direction relative to the expected return (which absolutely exists, the only reasonable debate is what's your estimate of it). Further, it's a convention to use 'CAPE' as the PE in that equation not inherently part of the derivation, but again those opposing it would need to show that a different measure of PE was a better estimator. The problem for them would be that almost without exception they'd like to say now that 1/CAPE understates the expected return, yet historically there has been some correlation of CAPE to subsequent return suggesting 1/CAPE would overstate expected return when CAPE is as high as now, because there's been a tendency to negative expected speculative return when valuation is very high. The equation 1/PE with PE taken as 'CAPE' doesn't assume that tendency.
rkhusky
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Re: Why don't you factor tilt?

Post by rkhusky »

Marseille07 wrote: Wed Sep 21, 2022 12:52 pm
dbr wrote: Wed Sep 21, 2022 12:10 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
There is no such thing as the expected return, not anything you can derive by looking at (CA)PE, anyway.
In the sense of computing the integral of return over the probability distribution, expected return of the stock market is not calculable. But conceptually, one can imagine that there is an expected return if one only knew the future probability distribution.
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Re: Why don't you factor tilt?

Post by muffins14 »

rkhusky wrote: Wed Sep 21, 2022 9:25 am
Random Walker wrote: Wed Sep 21, 2022 8:56 am
rkhusky wrote: Wed Sep 21, 2022 8:15 am
acegolfer wrote: Wed Sep 21, 2022 7:49 am
rkhusky wrote: Wed Sep 21, 2022 7:47 am
But estimating the difference in return of various categories of stocks is much more difficult than estimating the return of the overall stock market. The noise is apt to drown out the signal.
We were talking about beta. No need to estimate difference.
To estimate expected return in a factor model, you need to estimate differences.
True. I believe though, that one can and should be very rough and conservative in the estimates when guesstimating the factor premia. I believe this is pretty dicey territory since, in an effort to build a more efficient portfolio with a move towards risk parity, one most likely decreases overall equity allocation as he tilts the equities.

Dave
The problem is that you often can't tell if the premia will be positive or negative. I suppose if you can cap the absolute magnitude, you can get a feeling for how far from the market you might end up, either below or above.
Estimating the premia - point estimate + confidence intervals, + understanding significance, is a major output of the research in factor models.

The research has shown that the noise does not drown out the signal at least to the effect that the value premium was statistically significant in the original publication, and in the second publication with out-of-sample data, there is not sufficient data to reject the hypothesis that the premium pre-publication is different than the publication post-publication
Crom laughs at your Four Winds
muffins14
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Re: Why don't you factor tilt?

Post by muffins14 »

rkhusky wrote: Wed Sep 21, 2022 2:32 pm
Marseille07 wrote: Wed Sep 21, 2022 12:52 pm
dbr wrote: Wed Sep 21, 2022 12:10 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
There is no such thing as the expected return, not anything you can derive by looking at (CA)PE, anyway.
In the sense of computing the integral of return over the probability distribution, expected return of the stock market is not calculable. But conceptually, one can imagine that there is an expected return if one only knew the future probability distribution.
You can assume the new distribution will be similar to the past empirical data. Taking an expectation value of the historical data is a valid expectation of future returns without forcing an assumption of the mathematical form of the distribution
Crom laughs at your Four Winds
dbr
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Re: Why don't you factor tilt?

Post by dbr »

muffins14 wrote: Wed Sep 21, 2022 3:27 pm
rkhusky wrote: Wed Sep 21, 2022 2:32 pm
Marseille07 wrote: Wed Sep 21, 2022 12:52 pm
dbr wrote: Wed Sep 21, 2022 12:10 pm
JackoC wrote: Wed Sep 21, 2022 12:04 pm
We are trying to estimate the *expected return*, not predict the realized return.
Factors and all other discussion as well this is the single most important understanding about investing that there is. Understanding this would eliminate a huge volume of pointless discussion.
There is no such thing as the expected return, not anything you can derive by looking at (CA)PE, anyway.
In the sense of computing the integral of return over the probability distribution, expected return of the stock market is not calculable. But conceptually, one can imagine that there is an expected return if one only knew the future probability distribution.
You can assume the new distribution will be similar to the past empirical data. Taking an expectation value of the historical data is a valid expectation of future returns without forcing an assumption of the mathematical form of the distribution
Of course. The statement at hand is "estimate expected return." There is nothing impossible in that, just a question of how large you also want to estimate the probable or possible error to be.
Marseille07
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Re: Why don't you factor tilt?

Post by Marseille07 »

dbr wrote: Wed Sep 21, 2022 3:34 pm Of course. The statement at hand is "estimate expected return." There is nothing impossible in that, just a question of how large you also want to estimate the probable or possible error to be.
Okay...if we don't care about the accuracy then of course we can estimate for the sake of estimating. But the purpose of doing that is lost in my opinion.
Marseille07
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Re: Why don't you factor tilt?

Post by Marseille07 »

JackoC wrote: Wed Sep 21, 2022 1:19 pm 1. A bold statement but not only untrue but basically self-refuting if we go through step by step how anyone is constructing an investment plan except pretty extreme exceptions which would just prove the rule. 'Future stock returns could be equally likely to exceed or fall short of 20% pa or equally like to exceed or fall short of -20% pa, and that would make no difference in how I approached investing, because I don't know the future'. That's the implication of 'no such thing as the expected return'.
2. The relationship of 'CAPE' to expected return is so confused it's harder to interpret what this is supposed to mean. But expected return is definitely connected to PE:
Price of a stock can be represented as S=Div/(r-g) S the stock price, r the return, and g the dividend growth rate, or IOW r=S/Div+g, the return the perpetual payout of the dividend plus dividend growth. But dividend growth comes from earnings growth comes from return. Assume in equilibrium the real expected return on the stock (index) is the return on capital of the company (ies in the index). So restate the first equation as S= p*E/(r-(1-p)*r), where p is the payout ratio, ie Div=p*E, div growth rate is (1-p)*r. Therefore r=E/S.

It's up to anyone refuting that to show why in practice the inherent simplifications bias the answer consistently in one direction relative to the expected return (which absolutely exists, the only reasonable debate is what's your estimate of it). Further, it's a convention to use 'CAPE' as the PE in that equation not inherently part of the derivation, but again those opposing it would need to show that a different measure of PE was a better estimator. The problem for them would be that almost without exception they'd like to say now that 1/CAPE understates the expected return, yet historically there has been some correlation of CAPE to subsequent return suggesting 1/CAPE would overstate expected return when CAPE is as high as now, because there's been a tendency to negative expected speculative return when valuation is very high. The equation 1/PE with PE taken as 'CAPE' doesn't assume that tendency.
I think your math is correct on a per-stock basis. It doesn't mean that if you do the same math on 3000 other tickers, the same properties hold in aggregate.
abc132
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Re: Why don't you factor tilt?

Post by abc132 »

JackoC wrote: Wed Sep 21, 2022 12:50 pm Your misconception is more basic than factors as in 'factor investing' so I'll reiterate based on the more basic idea of estimating expected return. The estimate of expected return cannot be validly discarded because the past estimate of ex ante expected return did not period after period fall right on top of the subsequent ex post realized return. To ask the estimate to do that, for a risk asset, must be to basically misunderstand what expected return means.
Right, you make predictions that you can not ever be held accountable for because it is unknowable whether the estimate was even ever a good estimate. And yet you ask me to come up with a better estimate - I pick 0% overall benefit from factor choices after fees. I pick some factors to outperform and some to underperform and I expect factor proponents to say the ones that overperformed were obvious in hindsight even though they didn't choose them in advance. It's the same old song and dance, and you can look at the prior small + quality post in this thread to see it.
JackoC wrote: Wed Sep 21, 2022 12:50 pm And in actual practice as was covered ad nauseum in the recent thread on Ilmanen's recent book, as well as various other threads, it's easy to see that in general the range of both realized returns and ex ante expected return of 60/40 by simple fundamental measures, div yield+avg past EPS growth and nominal bond yield minus survey based inflation expectation respectively, were in the same ballpark for nearly 1900-1990, then expected returns steadily dropped to levels never seen in the previous period but realized returns did not as valuations marched basically monotonically higher since around 1990. There is IOW no obvious evidence from the past that either of those fundamental measures, E[r, real, stock]=div yield+long term past avg real EPS growth or E[r, real, nominal bond]=yield-expected inflation is a biased estimate. And you do in fact have to show that to reject them. You can't just say 'I' don't know': you can't make any decisions about investing without any assumptions about future returns except in the most extreme boundary case. 'There will be innovation and the market will hold up' is some kind of assumption, and not at odds with E[r]=2.4% div+1.5% EPS growth, (VT's div yield, assume world growth trend around 3% real, US EPS growth in 20 th century was 1.5% less than GDP growth), as wishy washy qualitative statements are generally unlikely to be at odds with specific numerical estimates. But one must make some assumption to choose how much to invest, the exceptions to which would tend to just prove the rule. And 3.9% is very significantly lower than the assumption 'expected return=past avg return', so it's important.

OTOH this risk asset/factor has higher expected return than that one, more difficult, especially for things which give no direct read on expected return. The whole stock market does partly (in the div yield though requires us to assess if expected EPS growth is higher/lower than past long run, here I'm assuming same), bonds do pretty completely (no better estimate than the yield to the investing horizon), the 'SCV factor' doesn't at all, it's basically only derived from past return history. That's the difference I see, if ever we could get past the basic confusion about estimating expected return vs predicting realized return. :happy
I choose 0% expected benefit from factor investing based on the idea that on average the market balances the known risk vs reward in investing decisions. As a simple example, when the cost to invest in SCV was 1% annually, around 1% annual premium should have been the expected premium regardless of the realized premium. I think you have to be a fool to expect 1% premium and diversification benefits based on analyzing that past data. There is no free lunch being offered.
Last edited by abc132 on Wed Sep 21, 2022 5:03 pm, edited 1 time in total.
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