VALUE: After Hours (S07 E17): Why Investing Formulas May Be Losing Power

During their recent episode, Taylor, Carlisle, Schwartz and Hanauer discussed Why Investing Formulas May Be Losing Power. Here’s an excerpt from the episode:

Jake: So, all for the last 10 years didn’t look as much like the 50 before them?

Matthias: Yeah, you’re absolutely right. So, this is also something that you see for many factors in literature. So, you see typically good returns before 2000. And then, you see sometimes around 2004 that there’s some decay of all factors. Probably has to do a bit that many of these factors were published just before or that liquidity improved the markets after 2004. I think before the decentralization of prices were introduced around that period that led to a higher liquidity. Maybe also more hedge fund quant firms trading on these signals.

So, I think one of these lessons from our paper, is that also these simple formulas probably need some continuous innovation. It’s not that you once come up with this one magic formula and you don’t have to revise it, because it’s just so magic.

Tobias: Or, you don’t tell anybody about it when you publish it. Or, you don’t tell anybody about it, you don’t publish it.

Matthias: Maybe. Yeah.

Tobias: Because it’s a phenomenon that it’s not just these formulas, I think most fundamental approaches to investing have struggled more over the last 10 years or so or even 15 years. It’s beyond publishing and being disseminated. What do you think is causing that?

Matthias: I think there are sometimes cycles also across factors. I think you always have to be careful when looking at back tested results, because these back tests, also papers, they are back tests are sometimes optimized. Researchers might look at 10 different ways how to measure one economic idea and then report just the best one. And therefore, if they all maybe have the same expected return but one was just lucky over the sample period, then you expect some decay for the best performing one.

But also, sometimes people say “Okay, this factor or this style is now dead. Typically, once this is set, the style reverses.” There we also have to be a bit looking at, “Okay, what is like the performance of a long-short signal versus of a long only strategy that’s versus the market?” because for instance in these long only strategies.

I remember for instance 2023 was a good or the average value stock was often outperforming the average growth stocks if you look at different universes. But most value strategies were underperforming the value weighted market, because you did not have included the magnificent seven stocks. So, there’s a bit the differentiation that you have to do. But for instance, some signals like accruals was told to be that and afterwards, this was written, we saw some comeback in this signals.

Tobias: Accruals went away for a little while after the paper was published, but it seems to be it started working again as the signal over the last few years.

Matthias: Exactly.

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