Factor Glut – The Eighth Portfolio Rule

Factor Glut – Eighth Portfolio Rule by David Merkel, CFA of The Aleph Blog

I use factors in my investing. What *are* factors, you ask?  Factors are quantitative variables that have been associated with potential outperformance.  What are some of these factors?

  1. Valuation (including yield)
  2. Price Momentum (and its opposite in some cases)
  3. Insider Trading
  4. Industry factors
  5. Neglect
  6. Low Volatility
  7. Quality (gross margins as a fraction of assets)
  8. Asset shrinkage
  9. Share count shrinkage
  10. Measures of accounting quality
  11. and more…

This is a large portion of what I use for screening in my eighth portfolio rule.  I’m not throwing this idea out of the window, but I am beginning to call it into question.  Why?

Seth Klarman: Investors Can No Longer Rely On Mean Reversion

Volatility"For most of the last century," Seth Klarman noted in his second-quarter letter to Baupost's investors, "a reasonable approach to assessing a company's future prospects was to expect mean reversion." He went on to explain that fluctuations in business performance were largely cyclical, and investors could profit from this buying low and selling high. Also Read More


I feel that the use of the most important factors are getting institutionalized, such that many major investors are giving their portfolios a value tilt, sometimes momentum tilts, and other sorts of tilts.  I also see this in ETFs, where many funds embrace value, yield, momentum, accounting, or other tilts.

Now, we have been through this before.  In 2007, momentum with value hedge funds became overinvested in the same names, with many of the funds using leverage to goose returns.  There was quite a washout in August of that year as many investors exited that crowded trade.

I’m not saying we will see something like that immediately, but I am wary to the point that when I do my November reshaping, I’m going to leave out the valuation, yield and momentum factors, and spend more time analyzing the industry and idiosyncratic company risks.  If after that, I find cheap stocks, great, but if not, I will own companies that are hopefully not owned by a lot of people just because of a few quantitative statistics.

I may be a mathematician, but I try to think in broader paradigms — when too many people are looking at raw numbers and making decisions off of them solely, it is time to become more qualitative, and focus on strong business concepts at reasonable prices.

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David J. Merkel, CFA, FSA — 2010-present, I am working on setting up my own equity asset management shop, tentatively called Aleph Investments. It is possible that I might do a joint venture with someone else if we can do more together than separately. From 2008-2010, I was the Chief Economist and Director of Research of Finacorp Securities. I did a many things for Finacorp, mainly research and analysis on a wide variety of fixed income and equity securities, and trading strategies. Until 2007, I was a senior investment analyst at Hovde Capital, responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. I also managed the internal profit sharing and charitable endowment monies of the firm. From 2003-2007, I was a leading commentator at the investment website RealMoney.com. Back in 2003, after several years of correspondence, James Cramer invited me to write for the site, and I wrote for RealMoney on equity and bond portfolio management, macroeconomics, derivatives, quantitative strategies, insurance issues, corporate governance, etc. My specialty is looking at the interlinkages in the markets in order to understand individual markets better. I no longer contribute to RealMoney; I scaled it back because my work duties have gotten larger, and I began this blog to develop a distinct voice with a wider distribution. After three-plus year of operation, I believe I have achieved that. Prior to joining Hovde in 2003, I managed corporate bonds for Dwight Asset Management. In 1998, I joined the Mount Washington Investment Group as the Mortgage Bond and Asset Liability manager after working with Provident Mutual, AIG and Pacific Standard Life. My background as a life actuary has given me a different perspective on investing. How do you earn money without taking undue risk? How do you convey ideas about investing while showing a proper level of uncertainty on the likelihood of success? How do the various markets fit together, telling us us a broader story than any single piece? These are the themes that I will deal with in this blog. I hold bachelor’s and master’s degrees from Johns Hopkins University. In my spare time, I take care of our eight children with my wonderful wife Ruth.