Evaluating Systematic Equity Strategies (EP.152)

Episode Summary

Executive Summary: In this episode, hosts Benjamin Felix and Cameron Passmore discuss the podcast's evolution beyond pure finance, review Katie Milkman's 'How to Change,' analyze the CPPIB's active management costs, and present a framework for evaluating equity factor strategies. They emphasize the importance of data persistence, economic rationale, and after-cost premiums, while warning against complex tax schemes like TFSA maximizers. The episode underscores the value of habits over goals and the need for skepticism in investment strategies.

Main Topics: Podcast Evolution and Listener Feedback (Priority: 3/5): The hosts reflect on positive reviews highlighting the podcast's shift from pure finance to broader life and mindset topics, and the accidental success of Cameron's book reviews. Book Reviews: 'Effortless' Retraction and 'How to Change' (Priority: 4/5): Cameron retracts his earlier criticism of Greg McKeown's 'Effortless' after finishing it, and praises Katie Milkman's 'How to Change' as a blend of Atomic Habits, Thinking Fast and Slow, and Nudge. News: Nevada PERS and CPPIB Active Management Critique (Priority: 4/5): Discussion of Nevada's low-cost passive approach vs. CPPIB's expensive active management, citing Andrew Coyne's article on CPPIB's high costs and underperformance relative to its reference portfolio. SPIVA Canada Persistence Scorecard (Priority: 3/5): First Canadian persistence scorecard shows almost no fund managers remain top-quartile over five years, reinforcing the difficulty of active management. Evaluating Equity Strategies: A Framework (Priority: 5/5): Ben presents criteria for assessing factor-based strategies: data persistence, economic rationale, not relying on rising valuations, after-cost premiums, and the 'what if I'm wrong' test. Includes discussion of implicit costs and factor model comparisons. Listener Questions: Purpose of Money and Goals (Priority: 2/5): Cameron defines money as a means to move economic value through time; Ben reveals he never sets numerical goals, focusing instead on habits and quality. Bad Advice: TFSA Maximizer Schemes (Priority: 4/5): CRA recently clarified that these schemes are subject to 100% advantage tax, and the hosts explain why the high-interest mortgage structure is commercially unreasonable.

Key Arguments: Factor strategies must be evaluated on data persistence across time and markets, strong economic rationale (risk-based or behavioral), and should not rely on rising valuations for historical outperformance. Implicit trading costs (market impact) can significantly erode returns, especially for high-turnover strategies like momentum (estimated 1.76% cost). After accounting for transaction costs, the Fama-French five-factor model may outperform more complex models like the q-factor or Barillas-Shanken six-factor model. The 'what if I'm wrong' test: if a factor premium doesn't materialize, the portfolio should still be reasonable (e.g., not overly concentrated or costly). TFSA maximizer schemes are commercially unreasonable and CRA has confirmed they trigger a 100% advantage tax, plus potential penalties. Setting numerical goals is less effective than focusing on daily habits and quality of work, as outcomes are not fully controllable.

Data Points: CPPIB annual return vs reference portfolio: 20.4% vs 30%+ - CPPIB reported 20.4% net return for fiscal year ending March 31, but its reference portfolio returned over 30%, indicating underperformance. CPPIB cost increase: $4 million in 2000 to $4.5 billion last year - Massive increase in spending since adopting active management, with employee count rising from 5 to 2,000. SPIVA Canada persistence: top-quartile funds remaining top-quartile after 5 years: 0% for most categories; 5.8% for Canadian equity (1 fund) - Only one Canadian equity fund remained top-quartile over five years, highlighting lack of persistence. Number of systematic factors identified in top journals by 2019: Over 400 - Indicates data mining concerns and the challenge of selecting genuine factors. Estimated trading cost for standard momentum strategy: 1.76% - Research Affiliates estimate for momentum in the 1,000 largest US stocks, compared to 0.09% for large-cap value. AVUV excess return estimate after 50% haircut and fees: 1.75% - Using regression loadings and halved historical premiums, AVUV (Avantis US Small Cap Value ETF) shows ~2% before fees, 1.75% after 0.25% expense ratio. Probability of 100 randomly selected stocks underperforming the market over 90 years: 57% - Bessembinder's bootstrap simulation shows even diversified portfolios often underperform the value-weighted market.

Pivotal Quotes: "The long run is lying to you." — Cliff Asness (paraphrased by Ben): Ben uses this to explain how rising valuations can distort historical performance comparisons, e.g., US vs international stocks. "I've never believed in goals. And I don't set goals, never have." — Cameron Passmore: In response to a listener question about goals, Cameron explains his focus on habits and quality rather than numerical targets. "What if I'm wrong?" — Benjamin Felix: Ben introduces this as a key test for factor strategies: if the premium doesn't materialize, the portfolio should still be reasonable.

Implications: Investors should critically evaluate factor strategies using a rigorous framework, beware of high-cost active management and complex tax schemes, and focus on habits and process over goals. The podcast reinforces the value of low-cost, diversified portfolios and the importance of understanding implicit costs and valuation effects.