25 April 2024

Factor Investing with Arnott and Asness: Morningstar Investor

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Asness: Quants maybe have more powerful tools to data-mine. But on the other hand, to Rob’s point, we have some hope knowing that we’re data mining and dealing with it. And echoing what Rob said, there are really two ways to protect yourself from data mining. One is having an economic story for why what you see works actually works. Now, of course, it could be a harebrained story just to fit the data, so you should always look for other things that fit that story, other examples.

What we’ve talked about at my firm for the last couple of years is why low-volatility investing works. We think we have a pretty integrated story, which is that it works because of another thing that scares investors, maybe with good reason: leverage. If investors eschew leverage, and they’re scared, all else equal, of a leveraged strategy, that will actually lead to low-beta and low-volatility investing working. That’s a story we’ve found very consistent around the world.


Arnott: Low volatility has tremendous merit, because the largest anomaly in the finance world is that the capital asset market line empirically is flat to inverted instead of upward-sloping. As so often is the case, the biggest profits in our business are found in areas where finance theory and the real world part company. Finance theory says, returns should be linearly linked to beta, and that line should start at the risk-free rate and move linearly upward to reward more beta with more return. The empirical reality is totally different from that, creating a wonderful investment opportunity.

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