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On The Statistical Significance Of The Knowledge Factor

Over the last week or so we’ve been highlighting how factor investing is not as cut and dry as advertised . The traditional simple factors (value, size, momentum, quality, low volatility) sometimes work and sometimes don’t so investors are left to make educated guesses about which factors will work in any given year. Here we’re defining “work” as these factors’ outperformance, or not, of the broad equity market. But the Knowledge Factor (the Gavekal Knowledge Leaders Developed World Index) doesn’t appear to have this same limitation. As we’ve shown already two times in the last five days, the Knowledge Factor – the tenancy of highly innovative companies to realize excess stock market performance – is the only factor that delivers consistent outperformance vs the global stock market. In the first chart below we show the yearly binary relative out/under performance of each MSCI Factor index relative to the MSCI World Index itself. A blue line and a +1 represents a year of outperformance for that factor and a red line and a -1 represents a year of underperformance. The results speak for themselves as it’s clear that there is no discernible trend in the out or underperformance of the five MSCI simple factors on a yearly basis. Said differently, sometimes the factor exposures outperform and sometimes they don’t. The top line that shows the Knowledge Factor’s relative performance is as stable as it gets, returning less than the MSCI World Index only twice in 16 years. Click to enlarge This next chart shows the cumulative performance since 2000 for each of the MSCI simple factors and the Knowledge Factor (the bars) and the yearly hit rate of outperformance relative to the MSCI World Index (the stars). Over time, the stable outperformance of the Knowledge Factor has resulted in by far the highest total return of any factor over the last two full market cycles. Click to enlarge Having laid out the above, we then analyzed the performance of the Knowledge Factor to see if there were certain market environments which were not supportive of the Factor’s outperformance. We looked at bull markets and bear markets, periods of rising and falling interest rates, periods of rising and falling commodity prices, and periods of rising and falling inflation trends. We observed no market environment in which the Knowledge Factor did not outperform the MSCI World Index, leading us to conclude that the Knowledge Factor is the gift that keeps on giving . Statistical Analysis: Today we want to take a slightly different tack to try to understand the sources of performance of the Knowledge Factor (the Gavekal Knowledge Leaders Developed World Index). We’re going to decompose the return of the Knowledge Factor to see if underlying simple factor tilts are the sole reason for this factor’s outperformance. If the Knowledge Factor is just an intelligent combination of the simple factors, then the return stream could be easily replicated and the relative performance of the Knowledge Factor described above would lose significance. To test the hypothesis that the Knowledge Factor adds value (aka Alpha) even after taking into account of any underlying factor exposure, we show a multiple regression of the since 2000 return stream of the Knowledge Factor (dependent variable) vs the all the MSCI simple factors (the independent variables). Given the below ANOVA table we observe the following: This factor exposure model does a good job explaining the return stream of the Knowledge Factor (the Gavekal Knowledge Leaders Developed World Index) because the adjusted r-square is .95, meaning that 95% of the Knowledge Leaders Index return stream is explained by this model. All of the beta coefficients except the Size Factor coefficient are in the single digits and none of the individual beta coefficients are statistically significant. In other words, there are no large factor tilts in the Knowledge Leaders Index returns and any factor tilts observed in the model cannot be statistically relied upon given the low t-stats and high p-values. Said even differently, none of the MSCI simple factors, in isolation or combined, can explain the returns of the Knowledge Factor. Even after taking into account the incredibly small and insignificant factor exposures, the Knowledge Factor has a highly statistically significant unexplained annualized alpha of 3.18%. We know the 3.18% alpha is statistically significant because the t-stat is greater than 2 and the p-value is close to zero. These results indicate that the Knowledge Factor is not simply an aggregation of the simple factors. The returns of the Knowledge Factor are all-together different than the return streams of the simple factors. This goes a long way in explaining why the Knowledge Factor consistently outperforms global stocks on a yearly basis and outperforms in all the market environments studied. There are no underlying factor tilts dictating the performance of Knowledge Leaders except the Knowledge Factor itself, which is the systematic mispricing of highly innovative companies. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

How Apple, Comcast, Google, Amazon Have Skin In FCC Set-Top Game

FCC Chairman Tom Wheeler aims to throw open the set-top box market, a plan that has Comcast ( CMCSA ), AT&T ( T ) and other pay-TV providers steaming but could take years to play out. The Federal Communications Commission plans to make it easier for consumers to switch from set-top boxes leased monthly from pay-TV companies to new devices sold at retail by consumer electronics or Internet companies. The pay-TV industry is worried about more than just losing revenue from monthly set-top fees, which usually run around $10. Apple ( AAPL ), Alphabet ’s ( GOOGL ) Google, Amazon.com ( AMZN ) and other new entrants would provide their own programming guide to consumers. Pay-TV firms fear losing the “customer relationship” and along with it the ability to collect viewership data, the key for targeted advertising. The FCC could approve Wheeler’s plan by year-end. Comcast, AT&T and other pay-TV firms would have two years to comply with technical standards that give new suppliers access to programming content. So in a worst-case situation, competing set-top TV devices could be available in 2019. As it is now, the set-top game is hit and miss. Some set-tops not from the pay-TV provider work with the pay-TV providers’ service, but others do not, depending on the set-top box, the pay-TV provider and the user’s region. And that scenario probably is not going to happen. Even if the current FCC approves Wheeler’s plan, a new chairman is expected to head the agency in 2017 after November’s presidential election. A Republican appointee would likely not follow through on the set-top market overhaul, while another Democratic FCC chairman might have other priorities, says Paul Gallant, an analyst at Guggenheim Partners. And if the FCC forges ahead with the set-top plan, a court battle is likely, and it could drag on. In the meantime, pay-TV companies would take steps to “maintain consumer inertia and impede adoption,” says Timothy Arcuri, an analyst at Cowen & Co. Cable companies have fought FCC attempts to open up the set-top market for 20 years. Will Set-Top Issue Become Moot Point? In a few years, the uproar over Wheeler’s proposal could be much ado over nothing, some observers say, as changes in technology and the way we all view video might make this a moot point. AT&T, for example, plans on selling DirecTV’s programming over the Internet starting late this year, and consumers won’t need the satellite TV broadcaster’s set-top boxes anymore. Some analysts say the future battle will be over the highest-spending consumers — the ones that now buy more premium channels,  pay-per-view and, in the future, might pony up for cloud movie storage or other perks. Those are the same subscribers advertisers will be interested in as well. Wheeler’s proposal zeros in on such users, and it’s “apt to emerge as the single biggest threat” to cable TV companies since satellite TV rivals emerged 30 years ago, says Citigroup analyst Jason Bazinet. “If Silicon Valley gets its way, pay-TV firms will provide the costly infrastructure to deliver bits of information,” Bazinet said in a report. “And they will provide programming at scale — relegating the pay-TV firms to being content wholesalers.” Here’s a run-down of some companies that have a stake in the set-top box battle, and the threats or opportunities it may present: Apple . It reportedly shelved plans for an Internet video service after programmers played hard ball in content negotiations. Under the new set-top rules, the FCC says that only pay-TV subscribers will gain access to programming and that copyright protections will be preserved. Even so, the FCC could clear a path for Apple into Web TV. Arris Group ( ARRS ). The supplier of set-top boxes to the cable industry seems vulnerable. But it could get a lift if cable TV firms race to upgrade their own set-top boxes. Barclays analyst Kannan Venkateshwar says Arris could also shift its focus to the retail channel. Amazon. The e-commerce leader, like Google, took part in an FCC task force that studied security issues in distributing content more broadly. Amazon, a player in subscription video-on-demand, has also been mulling a Web streaming service with live broadcast content. Comcast. By year-end, Comcast expects at least half of its 22 million video subscribers will be using Internet-ready, X1 set-top boxes — “the most advanced on the market today,” says a Moody’s report.  Barclays calls the X1 set-tops “arguably better than platforms like Apple TV today in terms of functionality. Whether Comcast can keep innovating is key if legal battles to halt the set-top initiative fail. Google. One of the FCC’s goals is making it easier for consumers to search for all content on both traditional pay-TV platforms, including video-on-demand, as well as across the Internet. That would play into Google’s strengths. And Google could swap its own advertising for the local ads sold by cable TV companies. Cable firms are worried that technical standards could result in revealing the “secret sauces” of set-top design to an archrival like Google, which “appears to be the primary backer” of the new set-top rules, says Jeffrey Wlodarczak, an analyst at Pivotal Research. Roku . The maker of video streaming devices has supported cable TV firms so far in the set-top box battle. Roku supplies devices to Time Warner Cable ( TWC ) and Charter Communications ( CHTR ), which both offer streaming deals to customers. Citigroup says pay TV firms prefer to have an app for their consumer offering, similar to how they work with Roku, rather than giving Google and others access to their content. Roku recently raised $45.5 million in a funding round. It’s not clear how the set-top box issue may impact any plans Roku has for an IPO. Rovi ( ROVI ). The provider of interactive programming guides main customers are pay-TV companies under licensing deals. Its new FanTV platform provides search and programming recommendations. Rovi also could be a “potential beneficiary,” says Cowen’s Arcuri, as cable TV firms try to improve offerings vs. new rivals. Tivo ( TIVO ). The  DVR pioneer has expanded beyond hardware sales and patent licensing to online subscription services. TiVo has been viewed as a possible seller of retail set-tops, like Google. But, its customers include small- and midsize pay TV companies . TiVo could provide more cable firms with next-generation features, including its cloud platform and mobile apps, analysts say.

What (Returns) To Expect When You’re Expecting

Investing decisions should always be made in the context of your overall financial plan. And although we know short-term forecasts are futile , a retirement plan needs to include some assumptions about returns and risk over the long term. To help with this important task, my colleague Raymond Kerzérho , PWL Capital ‘s director of research, has just updated our white paper, Great Expectations: How to estimate future stock and bond returns when creating a financial plan . As we explain in the paper, there are two main approaches to estimating future stock returns. The first is to rely on a historical premium: over the last 50 years, stocks have delivered returns of about 5% above inflation, so one could simply expect that to continue. The second approach raises or lowers that expected premium depending on whether stocks are currently undervalued or overvalued. You can apply similar methods to expected bond returns, using either the long-term premium (about 2.7% over inflation) or the current yield on a benchmark index. Both methods are flawed, but an average of the two is likely to be a useful estimate. Imagine that you are doing retirement projections going out 30 years. Using an expected return of 4.5% for bonds based on their long-term average seems wildly optimistic. But on the other hand, assuming bonds will yield just 2% for the next 30 years (based on their yield today) seems unnecessarily conservative. An average of these two estimates (3.3%) is a reasonable compromise. You can dig into the paper for all the details, but here are the numbers we’re using for inflation, bonds and stocks in our plans these days: Estimated long-term returns (as of December 2015) Asset class Expected return Inflation 1.80% Canadian bonds 3.30% Canadian equities 7.10% U.S. equities 6.30% International developed equities 7.20% Emerging markets equities 9.80% Source: PWL Capital And here’s how those numbers combine in various balanced portfolios. In the table below, we’ve also included the standard deviation (a measure of volatility) for each asset mix, and the maximum drawdown (or cumulative decline) experienced in similar portfolios since 1988: Expected return and risk of various portfolios Equities/Bonds Expected Return Standard Deviation Cumulative Decline 0% / 100% 3.30% 3.90% -11% 10% / 90% 3.60% 3.80% -10% 20% / 80% 4.00% 4.00% -10% 30% / 70% 4.40% 4.50% -10% 40% / 60% 4.80% 5.30% -14% 50% / 50% 5.10% 6.20% -18% 60% / 40% 5.50% 7.20% -23% 70% / 30% 5.90% 8.20% -28% 80% / 20% 6.30% 9.20% -33% 90% / 10% 6.70% 10.30% -39% 100% / 0% 7.00% 11.40% -44% Sources: PWL Capital, Morningstar Direct How low can you go? In this new edition of our paper (which was first published almost two years ago), we’ve added a postscript to help put these numbers in context. If you’ve looked at the returns of a balanced portfolio over the long term , you may be surprised (and disappointed) by the expectations we describe in the paper. Even since the late 1980s, traditional index portfolios delivered annualized returns in excess of 7% or 8%, even with a conservative asset mix, compared with our expectation of just 5.1% for a portfolio of half stocks and half bonds. Why so gloomy? The first important point is that over the last 20 to 30 years, bonds enjoyed a long bull market as interest rates trended steadily downward (10-year Government of Canada bonds yielded close to 10% in 1988). This cannot be expected going forward, so we think it’s reasonable to plan for conservative portfolios to deliver significantly lower returns in the foreseeable future. It’s also reasonable to expect equity returns to be lower than they have been since 1988. By traditional valuation measures, stocks are relatively more expensive today: for example, the S&P 500 had a price-to-earnings ratio of 14 at the beginning of 1988, compared with 24 at the end of 2015. Finally, inflation was 4% in 1988, compared with just 1.4% in 2015. The numbers in the tables above are nominal returns, which are not adjusted for inflation. Remember that a 6% return with 2% inflation is very similar to an 8% return with 4% inflation. When viewed in terms of purchasing power, the gap between historical returns and expected future returns is not as wide as it first appears. Disclosure: Holdings include: ZRE, HXT, XRB, XMD, VAB, VTI, VXUS.