Further Fighting On Element Models

A reader from a hedge fund (who wishes to rest anonymous) sends me about thoughtful comments almost element models. He has graciously allowed me to reprint them here:

"With regards to your weblog entry, 'The Robin Hood regime': this weekend I was truly too thinking almost the philosophy behind element models which y'all allude to inward the post. I am wondering if y'all own got whatever other thoughts equally to what service element models provide? Relegating them to 'just arrogant bets on the correctness of the managers' convictions' isn’t completely intellectually satisfying to me.

I facial expression at factors equally such: the returns I acquire for exposure to diverse factors tin hand notice come upward either because the marketplace is inefficient as well as systematically misprices those factors (alpha), and/or because I am providing about service via the exposure (and collecting about variety of guide chances premium associated amongst that service). My query #1 to y'all is, are y'all convinced that all of the returns to element models are indeed exactly from guide chances premiums as well as non alpha? If alpha exists, it’s less clear that a service needs to live on provided to the market, at to the lowest degree to me.

However, let’s assume (as I believe your boss did) that inward the long run, the marketplace is efficient. Then, y'all volition live on compensated for element exposure entirely past times bearing about guide chances or providing about service. In my mind, about detail conviction of a managing director doesn’t necessarily qualify for a guide chances element inward as well as of itself - I recall nosotros concur on that point. But are at that topographic point possible fundamental, valuation-based explanations behind these factors? Perhaps depression VALUE companies are mostly those companies amongst bad recent surgical procedure but which are expected to turnaround / mean-revert (as y'all somewhat propose inward your post) as well as the guide chances y'all conduct when buying a depression P/E fellowship is “turnaround risk”. Or mayhap high MOMENTUM companies are companies riding an manufacture tendency as well as y'all are bearing “trend continuation risk”. So, my query #2 to y'all is, are y'all convinced that at that topographic point are no such explanations?

If element models produce indeed work, it seems to me that at that topographic point must either live on existent risks behind the factors, or alpha, or both."

And hither is my response:

"I believe the service that about value factors render is the efficient resources allotment of uppercase to those companies that deserve them, exactly similar whatever value investors do. In this case, the factors promise to position these companies faster than humans can, as well as hence select uppercase to them sooner. I own got no declaration amongst these factors equally they too render liquidity, albeit on a longer time-scale. However, amongst regard to diverse momentum factors, they are inward fact exactly betting on for certain behavioral characteristics of investors, or on the ho-hum dissemination of news, etc. You tin hand notice debate that they render a service past times improving the efficiency amongst which data almost companies disseminate. But the work is that i time everybody are using these momentum factors, the marketplace becomes efficient as well as whatever farther bets generate losses.

So I am quite willing to select that many of these (momentum) factors stand upward for alpha, but these factors are generating to a greater extent than losses equally to a greater extent than investors employ them. I am too willing to select that many of the (value) factors stand upward for guide chances premia. As to a greater extent than investors employ these, the net goes to zero, but fortunately non negative equally the guide chances too disappears."