Value

The Long Run Is Lying to You

Topics - Value Factor/Style Investing Factor Timing

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The Long Run Is Lying to You

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Everyone knows the value strategy has been a grave disappointment out-of-sample since, say, 1990 (thirty years!). And everyone knows the value strategy has been quite bad for the last 10+ years with the 2018–2020 period essentially a crash. Well, that’s all kind of true. But, as odd as this might sound, the realized average return on a strategy is not necessarily the best estimate of its true long-term expected return. In fact, the right estimate of the true long-term expected return of the value strategy is considerably higher than many might think if they were to just look at simple past returns – especially right now. Why?

Well, because one of the major things that buffets realized average returns is changes in valuations. To state the obvious, when strategies get more expensive, all-else-equal they do better while that richening is occurring. Yet to assume these changes are the expectation going forward, as simply examining past returns does, strikes us as folly. I examine the returns on various markets, market differentials, and most importantly, the value factor, using a regression framework that accounts for these valuation changes.

Doing so we find considerably different estimates of long-term expected return for traditional stock market beta (lower than just examining simple realized returns), USA vs. EAFE (EAFE is better than you think!), and again our biggest focus, the value strategy (woefully underappreciated due to extreme cheapening that seems crazy to forecast continues in perpetuity). 

In addition, this framework lets me stress a point that I think is grossly underappreciated, that valuation changes unnecessarily reduce the precision of our estimates of true long-term expected returns (market and factor). All considered, the usual examination of long-run average returns is not all it’s cracked up to be.

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