O'Shaughnessy On Active Management

by: Paul Novell

Recently, Jim O'Shaughnessy, the author of What Works On Wall Street, took to Twitter with his first tweet storm (basically a short post in a series of tweets). In it, he spoke about his thoughts on active management. I thought I should capture it for future reference. I'll add comments and links throughout.

What Works On Wall Street (4th edition) is basically 681 pages on a handful of factors; mainly value and momentum, with minor roles played by small-cap, equal-weighting, and quality.

The lack of ability to focus on the long term is the number one behavioral issue that prevents investors from being able to execute the strategies outlined in the book. It is also the biggest issue in preventing investors from even achieving the posted returns for index funds (see total returns versus investor returns on Morningstar, for example).

Here is the link to his base rate post. Base rates are one of the most important and overlooked aspects of choosing a strategy. Strategies with higher base rates will be easier to stick to in the long run. Choosing strategies with high base rates increases your chances of success. Here is a post I did on base rates.

Another really hard thing for investors to focus on - process. Especially in today's financial news, social media world. You need an investing process that actively tunes out noise. For me, one of the most valuable parts of What Works On Wall Street is O'Shaughnessy's discussion of process.

Composite factors versus a single factor is key. Companies are capitalized in different ways and are in vastly different businesses. Just because they are cheap on one factor doesn't mean they're truly a value. Also true in reverse. Now for some nitty-gritty details.

The VC2 (Value Composite 2) ranking used in the quant strategies here is an equal-weighted composite of these plus P/B. O'Shaughnessy used P/B in the latest edition of the book, but seems to have dropped it since. See this post. P/B works, but has long periods of underperformance. I still use it in my VC2. During my backtest period, back to 1999, the VC2 with P/B outperforms.

Related to #4. What you don't own matters a lot.

Back to a higher-level focus now...

See here on 3-year track records. Long-term proven strategies are the way to go.

Here is the link in this tweet. Rebalancing helps take some of the sting out of underperformance.

This is so important. Your worst enemy as an investor is staring at you in the mirror.

Don't ask yourself this after a good year. For example, right now quant investing looks fantastic after a stellar 2016. It didn't look so great at the end of 2015, though.

Agree 100%. I even believe there are some investors whose only real option is to be in cash or the shortest term of safe investments. They can't even take the volatility of 10-year government bonds. But the best approach would be to just hire Vanguard for 0.3% per year.

A good advisor can really help. But only if you understand their process so you don't fire them after a few years of underperformance.

There you go. Lots of gems in here to remember for the long term. If you're interested in quant investing, you need to go read the book.