Factor Vs Alternative Smackdown?

DFA kind of invented factor investing. We talk a little bit about factors here but the group used to be pretty narrow in terms of funds available targeting growth or value, the funds from Research Affiliates seem to focus on what might now be called quality. I think there have been dividend-centric funds for a good while and the field has grown in the last 15 years or so to include, low/high volatility, momentum, I would include buybacks, various options overlays and people also include size as well plus all the ones I am forgetting. Factor funds very generally try to look like the equity market (I'm sure there are bond factor funds but not the topic today), trying to do better than market cap weighting (MCW) which is itself a factor. These are stock market proxies. 

Alternatives fall into a few different categories, at least a few including absolute return/market neutral which I've described as horizontal lines that tilt upward, diversifiers that fairly reliably go the opposite direction as the equity market, multi-strategy/multi-asset that try to always outperform and this area could be dissected further but the big point is these are not stock market proxies. 

DFA posted a brief paper called Liquid Alternatives: Panacea Or Just A Pain. Cliff Asness from liquid alternative titan AQR Tweeted about this and wrote a rebuttal to the DFA piece here. 

Here are the DFA "key takeaways";

The paper belies a pretty serious lack of understanding of what alts are supposed to do. If you don't believe in using liquid alternatives, don't use them, that's pretty simple but if you're going to draw a conclusion one way or the other, you might want to have a little better understanding than DFA purports to have. 

First is that alts are not a single category which is kind of implied in the first two points. Some are negatively correlated to equities but some are not, some are positively correlated and they are likely to look different than the ones that are negatively correlated. 

I don't see too many alts providers talking about better nominal returns but maybe there are some. They might be talking about better risk adjusted returns. Well some do provide better risk adjusted returns and some do not. Some outperforming and some underperforming (however you define) is not a new thing and not unique to the liquid alt universe. 

Cliff Asness jumps on the period DFA studied, 2006-2022, as being cherry-picked. That is less interesting to me than the comment about fixed income. Assuming they mean the Aggregate Bond Index, well yeah, the Agg has spent a lot of time trading with pretty close to equity beta. As far as alts trailing equities, I say all the time, all the time, I as a big user of alts, that equities are the thing that goes up the most, most of the time. If your alts are your top performing holdings, then things are probably not going too well, 2022 as the latest example of this point that we repeat often here.

The conversation, which appears to elude DFA's understanding, is about whether or not it makes sense to try to manage equity volatility in a diversified portfolio and if it does, whether alts can do the job better than bonds or to what extent it makes sense to own some alts and some fixed income which is the camp I am in although I am severely underweight any sort of duration. 

Maybe DFA thinks alts have fallen short but when I look at the GFC and 2022, I would say that alts generally did what I think holders of alts would hope for. Not all did well. On the next go around, there will be others that don't do well. The answer there is diversify your diversifiers and use alts with different expected attributes. Managed futures should look much different than merger arbitrage for example. There's at least one alt strategy, so there must be more than one, that I don't think can work in a mutual fund/ETF wrapper which is risk parity. I had a Twitter convo once with someone who said managed futures is a form of risk parity which I don't understand, I am talking about the leveraging up on fixed income kind of risk parity. 

There are valid arguments against using alts and if I were trying to defend the factor fund shield the way I think DFA is, I might want to go after the alt space in a more informed and intelligent fashion. 

While we're sort of talking about factors, check out this chart. I built it a few days ago, waiting to figure out how to put it into a blog post. The chart captures the dividend factor, equities with an option overlay, quality + momentum, buybacks, minimum volatility and MKW. Build this chart yourself and then slide back in time and you will see none of the factors always beats MKW. MKW doesn't lead very often and the factors tend to have time outperforming or lagging. 

In terms of generally capturing MKW longer term, I think all of the ones I charted do but I would note momentum occasionally diverges dramatically for the better and for the worse and minimum volatility seems to lag by a lot when MKW booms.

I have no real point to drive home about factors, I think there can be room for factor fund in a portfolio that relies on broad based funds but all factors have advantages/disadvantages and it it crucial to get a handle in this context on the factor fund(s) that you think you want use. 

Contrary to DFA's opinion, there is room for alternatives to coexist with factor funds, one does not rule out the other, quite the opposite actually. 

I don't any of the funds charted personally or for clients.