How Can A Strategy Still Work If Everyone Knows About It? by Cliff Asness, AQR

Some assert that once a strategy is “discovered” it can’t work anymore. Others, often implicitly, assume the future will look as wonderful as the past. Perhaps not surprisingly, we stake out a middle ground. We’re going to argue that certain well-known classic strategies that have worked over the long term will continue to work going forward, though perhaps not at the same level and with different risks than in the past.[1] We will focus on classic “factor”-type strategies.[2] Our favorites won’t shock anyone. They are things like value, momentum, carry and quality/defensive.[3] Of these, we’ll use value investing as a common example throughout this discussion.

We don’t consider these classic strategies to be “alpha” in the traditional sense. However, there can be better or worse versions of them, and creating new, better versions is certainly a form of alpha (this can lead to great semantic battles).[4] Still, to be real alpha something has to be known to only a modest number of people/organizations (one being optimal). By this definition, classic strategies defined in well-known ways don’t fit. But, presumably sometime in the past, when they were much less well-known, they were indeed at least closer to “alpha” in all senses of the word. This brings us to the title question — now that they are “classics” and known to many, why should they still work?

First, of course, let me say that all else being equal, everyone would prefer that only they knew about these strategies! It is hard to argue that widespread knowledge of them is a good thing for those few who knew about them before. We think in the past we (the “we” is those collectively doing many of these systematically 20-25 years ago) were in the position of knowing about these strategies and using them when they weren’t widely known. We believe that many strategies make a journey from alpha to a middle ground. This middle ground is a place where they are known, still work — though perhaps not at the same level as in the past — and eventually fall under a set of overlapping labels like alternative risk premia, style premia, priced factors, exotic beta, and, of course, smart beta. When you realize this journey has occurred, there are two important things you must do. First, decide if you really believe the strategies will work going forward. That is, are they now really “premia” or are they gone? Importantly, if you believe they will keep working, be cognizant of how they might act differently now that they are more widely known, both from return and risk perspectives. Secondly, make sure these strategies are available for a fee consistent with something being known and not with the higher fee appropriate if you believe something is true, unique alpha.

If you believe in these classic strategies going forward, and you can invest in them at a fair fee, we think they are very special in the investment world. They can be a source of return with very low correlation (either low correlation of total return if delivered in a long/short structure or of potential outperformance as long-only factor or smart beta strategies) with the rest of most investors’ portfolios. Let me adapt an old joke. In four corners of a room are (1) Santa Claus, (2) the Easter Bunny, (3) classic known factors and (4) high capacity, truly unique alpha that you can identify ex ante and invest in at a high but fair fee. A prize is placed in the middle of the room. Who gets it? The answer is the classic known strategies because the other three don’t exist.[5] And yes in our anthropomorphic example (3) and (4) are living beings desiring the prize!

Why Do Systematic Strategies Work to Begin With?

So, now we begin to tackle our main question. Why, even if something has worked for 100 years in a variety of places (actually especially so, as this is how it gets to be “known”), can well-known classic styles still work going forward? To start, of course, we have to discuss why any, known or unknown, systematic strategy (be it “factors” or smart beta) works to begin with.[6] Basically there are two reasons.

The first reason is they work because the investor is receiving a rational risk premium. Let’s use as our example the value factor among individual stocks[7] — going long cheap stocks and short expensive stocks (use your favorite metric or metrics for measuring valuation). If the long (cheap) stocks are, in some relevant sense, riskier than the short (expensive) stocks — and riskier not just individually, which can be diversified away, but as a portfolio — then it’s completely rational for them to be awarded a higher expected (or average) return. Now, keep in mind, to be risky, that investment has to lose sometimes, particularly when it really hurts to lose! This is something often lost as some investors assume that risk is simply that something occasionally goes down. That would indeed be risk if it was all you owned, but it isn’t the right measure of risk for a small part of a portfolio. Rather, winning on average is the compensation you get for the times you lose only if those are very painful times to lose (and, yes, the industry is still debating how to define this pain, with the CAPM’s answer being that it’s about falling when the overall portfolio of invested wealth falls). If you win or lose completely randomly, most theory, and basic intuition, says you are not compensated for it with higher expected return as this randomness can be diversified away.

The second reason these strategies may work is because investors make errors.[8] Errors, mispricing, inefficient markets, overreaction, underreaction and myopia of various kinds are all in the bailiwick of behavioral finance. In this case, following our value factor example, the long (cheap) stocks have higher expected return not because they are riskier, but because investors make errors. In other words, these stocks are “too cheap” and you make money when things return to rational (or from the superior carry while you wait), and vice versa for expensive stocks.

Of course, just to complicate things, these explanations are not mutually exclusive. They can both be true. Furthermore, their relative impact can vary through time. For example, cheap value stocks might usually be cheap because they are riskier, but in the 1999–2000 technology bubble they were too cheap because investors were making errors. Much ink has already been spilled by researchers arguing over these competing explanations (though few seem to explicitly deal with the annoyingly complex possibility of both mattering). It’s not our task here to adjudicate between them. Rather, we’re focused on what happens as a strategy that works for either reason becomes more known.

What Happens When a Strategy Becomes Known?

Let’s consider the first case where a strategy works for “risk”-based reasons. The good news is this strategy may remain fairly robust after becoming “known.” In fact, it’s odd to think of it as ever being unknown. If cheap

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