Good Strategies Aren’t Always Intuitive, Plus Other Morningstar Conference Notes

Right on the heels of the Berkshire Hathaway shareholder meeting, I turned around and went to the Morningstar Investment Conference last week. This annual conference is focused on mutual funds and exchange-traded funds (ETFs). It is primarily attended by advisers, with many mutual fund, ETF and financial services companies exhibiting. I don’t know if it was because of the length of the bull market, fee compression, a combination of the two or something else, but the amount of exhibitor swag being given out to entice attendees to stop by booths was—by my admittedly unscientific observation and tally—at a new low. Lots of pens, some notebooks, some reusable shopping bags, a handful of tees and (as a sign of the times) a few metal straws. There were also individually wrapped s’mores with a note attached describing them as “for investment professional use only.”

As far as the presentations are concerned, Cliff Asness, the chief investment officer of AQR Capital Management, discussed quantitative strategies in a different light than is typically heard. Rather than focusing on specific traits to seek out, he discussed the difficulty of sticking with them. The word he commonly used was “intuition.”

Quant strategies, including factor strategies, identify stocks based on numeric traits. A simple quantitative strategy could be one targeting stocks trading at low price-to-book ratios. It’s intuitive because it invests in cheaply valued stocks. When returns are good, value is in vogue. When it doesn’t work, value must not be working. It’s an easy strategy for investors to grasp and for advisers to explain.

Single-factor strategies, such as value, can be improved upon by adding in additional factors. Quality traits can weed out those companies that deserve low valuations. Size seeks out smaller companies, which have greater odds of being mispriced. While returns are enhanced, the increased complexity from combining strategies makes a strategy more difficult to grasp. A multi-factor strategy is less intuitive because there are moving parts as opposed to a single key factor. When the strategy lags, it’s less clear why the strategy didn’t work. The complexity leads to a line of thought Asness described as “when it loses, I can’t explain it so I’m not going to do it.”

He called this mental hurdle a “design feature” of quantitative strategies. Since there is an aversion to following less intuitive strategies, they are less likely to be too crowded. One of the big risks to any strategy is having too much money invested in it. Popularity diminishes returns. Being a maverick can boost your returns, as long as your strategy is based on historical data about what works and you have the discipline to stick with it over the long term.

Though I spent much of the Morningstar conference meeting with people (and laying the groundwork for future AAII Journal articles), here are some other takeaways I have:

• Discipline and how risk is viewed were subjects of Morgan Housel’s presentation. “Good investing is not about what you know, it’s about how you behave,” the Collaborative Fund partner told the audience. He went on to describe how people anchor their views of risk based on their personal experiences. For example, the returns of stocks when a person first started investing often establishes preferences that stay with them for the remainder of their life. Difficult market conditions are likely to lead to a lifetime of being more conservative, while good market conditions are likely to lead to a lifetime of risk-taking.

• The concept of risk and perception came up again during a panel on value investing. BlackRock’s Holly Framsted described the risk in value strategies as being the drawdowns (negative returns), which are followed by big upswings. Alpha Architect’s Wes Gray responded by telling the audience to either “own the risk” or not. Investors should avoid value strategies if the volatility makes it difficult for them to stick with them. O’Shaughnessy Asset Management’s Patrick O’Shaughnessy said he likes to see lengthy periods of underperformance because it scares people away and prevents traders from trying to arbitrage away the strategy’s upside.

• Morningstar’s Daniel Needham displayed what he called a “contrarian investor’s checklist.” Among the questions to ask: Are most investors underweight? Are earnings expectations low relative to history? Is sentiment negative? Is volatility high? And, are valuations low relative to history and similar assets?