How Serendipity Plays a Role in Returns
One of the great challenges for investors is distinguishing between luck and skill when evaluating performance. Many managers will heavily tout their strategies as being the reason behind outperforming returns. However, the culprit can just as easily be luck.
Let's look at an example from Research Affiliates, which touts on its Web site that it will "focus on research that results in superior investment products." Fortunately, we have live evidence showing us if the strategy outperforms or is just lucky.
The Research Affiliates Fundamental Indices (RAFI) are value-based strategies that weight the holdings based on four fundamental factors
- Sales
- Earnings
- Dividends
- Book value
These indexes reconstitute each March. Since they only reconstitute on an annual basis, funds based on these indexes will lose exposure to the value factors over time, meaning they'll continue to hold stocks that have outperformed and migrated out of the asset class. (By comparison, DFA reconstitutes its benchmarks on a daily basis, and Bridgeway does so on a monthly basis to avoid this drift, which lowers expected returns.)
We can see this in the results of a three-factor regression for the PowerShares FTSE RAFI US 1500 Small-Mid Portfolio (PRFZ) (so we can see data from a live fund) covering the period inception (October 2006) through June 2010. PRFZ's average exposure to the value factor for April through September of each year was 0.45 while it averaged just 0.21 from October through March.
We see similar results for the Power Shares FTSE RAFI US 1000 (PRF), a large-cap fund. Since inception (January 2006) through June 2010, the fund's average exposure to the value factor for April through September was 0.55 and just 0.35 for October through March.
Using the MSCI indexes, it turns out that the value premium in the U.S. was 0.09 percent per month for the April-September period, but -0.36 percent per month for the October-March period. Since there's no evidence of such seasonality in the value premium over the long term, the seasonality in the RAFI's value tilt worked out better than anyone could have hoped -- serendipity played a role.
Interestingly, for this particular period, the same seasonal pattern appeared around the globe. For the 23 countries in the MSCI indexes used to calculate the value premiums, the average value premium (averaged across countries) for the period December 1, 2005-December 31, 2010 was 0.14 percent per month in April-September (when the RAFI indexes had a greater exposure to the value premium), and -0.69 percent per month in October-March (when the RAFI indexes had a lower exposure to the value premium). The value premium was stronger in April-September than in October-March for 15 of the 23 countries.
Obviously, if the seasonal pattern in the value premium persists, the returns of the RAFI indexes will look favorable compared to a more constant exposure to the value risk factor. But, there's no reason to expect that to occur.
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