In searching for more articles on Shiller’s CAPE Ratio, I came across this article, The Mysterious Factor ‘P’. What particularly grabbed my attention was the person being interviewed, Robert Novy-Marx, as he is a former student of mine. I might add – a stellar student. While I recommend reading the entire interview, pay special attention to the last question and answer.
Q. Now that quality it hot, do you have any comments on the way different funds are implementing the quality factor into their offerings? Are there some approaches that you think work better than others (I understand that you consult with AQR Capital on their fund design)?
“Arguably, the most important thing an investor can do is to diversify, whether it is across geography, assets classes or factors and styles. Profitability needs to be traded with value, and once you’re trading value you really should also trade momentum. Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses. Thus, an approach that combines these three themes using an integrated, straightforward methodology that is designed to endogenously and efficiently capture these themes and take advantage of their natural synergies is ideal.”
The investment philosophy of ITA aligns with Robert Novy-Marx advice. We use non-managed index ETFs and diversify all over the globe. Portfolios are skewed or tilted toward small-cap stocks (VOE and VBR) as well as value. We employ a risk reduction model based on momentum principles. What we don’t do is work profitability into the equation as one needs to focus on individual stocks to bring that off. The closest I come to that is to hold shares of BRK.B (BRK-B on Yahoo!) in a few portfolios.