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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 Well Are The Largest Global Mutual Funds Protecting Your Capital?

Summary Over the last several months volatility has reasserted itself as a feature of the global stock markets. As is often the case when the tide rolls out (AKA volatility reemerges) those who have been swimming naked get revealed. In the mutual fund world, this is akin to seeing which funds have working risk management protocols and which funds have malfunctioning risk management protocols, or none at all. Overall, we have found that for the vast majority of the largest global funds, the risk management protocols seem to be either malfunctioning or non-existent. Over the last several months volatility has reasserted itself as a feature of the global stock markets. As is often the case when the tide rolls out (AKA volatility reemerges) those who have been swimming naked get revealed. In the mutual fund world, this is akin to seeing which funds have working risk management protocols and which funds have malfunctioning risk management protocols, or none at all. Overall, we have found that for the vast majority of the largest global funds, the risk management protocols seem to be either malfunctioning or non-existent. The vast majority of these funds are exposing investors to even more downside risk than the broad market and the funds that have declined less than their benchmarks have only declined a fraction less. Method: In the study carried out below we reviewed the performance of every World Stock and Diversified Emerging Market mutual fund with assets under management (AUM) greater than $1B. We limited the study to I and Y share classes so as to capture the share classes with the lowest fees and we only studied one share class per fund (the lowest fee class) if the fund has both I and Y shares. For each fund category there were 33 funds with an AUM greater than $1B. For World Stock funds we measured total return performance relative to the MSCI World Index since its peak on 5/21/2015 and for Diversified Emerging Markets Funds we measured total return performance relative to the MSCI EM Index since its peak on 4/28/2015. As of the close on 8/24/2015, the MSCI World Index was down 11.9% and the MSCI EM Index was down 26.6%. Results for the Largest World Stock Mutual Funds: Since the MSCI World Index (proxied by URTH ) made its cyclical peak on 5/21/2015, 36% of World Stock funds have gone down less than the index and 64% of funds have gone down more than the index. The average World Stock fund has realized 95.7% of the decline and thus was able to sidestep only 4.3% of the decline. The median fund has realized 97.2% of the decline and thus was only able to sidestep 2.8% of the decline. That is to say that the average fund avoided 51 basis points and the median fund avoided 33 basis points of the 11.9%, or 1189 basis point, decline of the MSCI World Index. Only four of these largest 33 funds have been able to avoid 20% of the decline and only one fund has been able to avoid 40% of the drawdown so far. We must conclude then that in general the largest World Stock mutual funds have provided no or de minimis capital preservation characteristics during this drawdown. Almost all of them have been swimming naked. Tables 1 and 2 below summarize these findings. (click to enlarge) Results for the Largest Diversified Emerging Market Mutual Funds: Since the MSCI Emerging Market Index (proxied by VWO ) made its cyclical peak on 4/28/2015, 21% of Diversified Emerging Market funds have gone down less than the index and 79% of funds have gone down more than the index. The average Diversified Emerging Market fund has realized 92.3% of the decline and thus was able to sidestep only 7.7% of the decline. The median fund has realized 93.2% of the decline and thus was only able to sidestep 6.8% of the decline. That is to say that the average fund avoided 205 basis points and the median fund avoided 181 basis points of the 26.6%, or 2659 basis point, decline of the MSCI Emerging Market Index. Only three of these largest 33 funds have been able to avoid 20% of the decline and not one has been able to avoid 40% of the drawdown so far. Much the same as our conclusions for the World Stock funds, we must conclude that in general the largest Diversified Emerging Market mutual funds have provided no or de minimis capital preservation characteristics during this drawdown. Almost all of them have been swimming naked. Tables 3 and 4 below summarize these findings. Discussion: As a group the largest global stock funds seem to be providing investors with no or very little risk management or capital preservation features. In fact, the vast majority of global mutual funds seem to be exposing investors to even more downside risk than the broad stock indexes they are designed to outperform. Of the funds that have been able to outperform the broad indexes, most have done so by no more than a rounding error. While an obvious statement, investors that want different results than those provided by the largest global mutual funds must look to products that perform differently than the market. This can be accomplished in two ways. One can look to rules based investment strategies like smart beta ETFs that have unique selection and weighting processes, or one can look to highly active and unconstrained mutual funds that have both high tracking error and different holdings relative to their benchmark. Most likely, investors will have to venture outside of the largest ETFs and mutual funds to find products that meet those characteristics. MDISX , OGLYX , VEMRX , ODVYX , DFEVX , DFCEX , LZEMX , FEMSX , HEIMX The original posting of this article can be found here . All data was created by the author and sourced from Morningstar, FactSet and Gavekal Capital Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) 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.