2022 was an excellent year for me. OK, I didn’t make as much from my investments as I did in 2020 or 2021—who did?—but a 22% return isn't bad.
But more important than how much I earned is how much I learned. Was this a better year than most? I don’t know. I learn a lot every year. But with every lesson I learn, I realize how stupid I was the year before.
So here are some things I learned in 2022, in no particular order at all. This article will discuss seven things—the other 15 are either covered in Part One or will be covered in Part Three.
1. Factor momentum doesn’t work.
Factor momentum is the idea that groups of factors go in and out of favor and that there’s enough lag time in those shifts for investors to take advantage of them. For example, if, in the last month or two or three, value has done really well and stability has done really badly, you can invest in value stocks and short stable stocks for the next few weeks until another shift occurs.
This idea, like many, presents two problems. First, how does one measure whether it actually happens? Second, if it does, how can we best take advantage of it?
Last summer, I thought I had the answer: it does actually happen, and I can take advantage of it. So I switched my strategy so that my multifactor ranking system placed heavier weights on factor groups that had done well in the last three months and less weight on factor groups that had done badly.
The result was insane turnover. From week to week the factor groups would shift and I ended up doing so much buying and selling that I lost a lot of money. After two or three months I gave up.
But for the purposes of this article, I’d like to start from scratch.
Portfolio123, a company that allows you to create, backtest, and invest in your own rule-based strategies, and the only service that allows you to both rank stocks and backtest your ideas, has created what they call “Core” ranking systems that each focus on one group of factors. (To give credit where credit is due, these ranking systems were created by Marc Gerstein and subsequently modified by Gerstein, Riccardo Tambara, and myself.) There are six such systems, focusing on growth, low volatility, momentum, quality, sentiment, and value. While I have some issues with some of the factors in these systems, they’re generally sensible. I’ve taken the liberty of adding a seventh, focusing on size (favoring small stocks), for the purposes of this experiment.
Here is how I propose to measure factor momentum.
First, I will use a bucket test for each ranking system and determine its slope. A bucket test is a measurement of the performance of the worst ten percent of companies, the next worst, and so on, until the best ten percent. I call it a bucket test because at every rebalance period (monthly), every stock is put into one of ten buckets according to its percentile rank on the factor group in question. So if I’m testing the value factors, the cheapest stocks are in the first bucket and the most expensive ones are in the tenth. The slope is the result of a linear regression of the ten-bucket annualized returns, regressed to the series 0.1, 0.2, 0.3, 0.4, . . . 1.0. It approximates the difference between the tenth bucket and the first and adjusts for the various buckets in-between.
I’ll do this for the last three months, since the one-month values are crazily variable, and I’ll also do it for the last eight years, to give me something to compare the last three months to. The final measure of factor momentum is the three-month slope minus the eight-year slope. Because I only have data going back to 1999, that means I can’t actually start the monthly measure until 2007, since that’s the first point at which I’ll have eight years of data to use as a benchmark.
I’ll be measuring performance using a group of US stocks that Portfolio123 has labeled “easy-to-trade.” These are listed stocks with a price greater than $3 and a median daily dollar volume greater than $50,000, excluding MLPs.
This is the result (click to enlarge).
As you can see, there’s not much persistence. You don’t see one factor outperforming over a years-long period. (The percentage numbers on the left represent the outperformance of the top bucket over the bottom bucket over the last three months, annualized, minus that same outperformance over the last eight years, annualized, and adjusted for how smoothly the in-between buckets rank.)
Now let’s say that every month you invested in the top bucket of stocks according to the factor that performed the best over the previous three months and shorted the bottom bucket of stocks according to the factor that performed the worst over the previous three months.
The result would be absolutely disastrous. You’d lose almost 4% per annum. You’d do far better investing in all of the top ten buckets and shorting all of the bottom ten than choosing just one based on factor momentum.
In short, if factor momentum actually works, I haven’t been able to verify it.
2. European stocks are easier to evaluate than US stocks.
This is the subject of an article I wrote last year, and I still stand by it. Unfortunately, they’re harder to trade . . .
3. If you think you've got a talent for getting good fills, you're probably fooling yourself.
Sorry for the second person—I’m talking about myself here. Until 2022 I thought I was able to get better fills than most other investors by placing my limit orders at the right point and at the right time and adjusting them using a pretty smart method.
But I don’t think so anymore.
If it were even remotely possible to get better fills by placing limit orders at certain points and certain times, everyone would do it. 97% of day traders lose money, but that wouldn’t be the case if they could consistently get good fills. Identical pair trading—buying a stock in one account and selling it in another—would be a great way to make money if you could identify when a stock was likely to be at its low and high point for the day. The arbitrage opportunities would be unbelievable. But it’s not happening.
If you’re not worried about market impact or spread costs, it doesn’t matter when you place your order. Spreads tend to be narrower at the end of the day, so that’s a good time to place orders if you want to minimize those costs. VWAP orders (small orders automatically placed throughout the trading day) minimize market impact, so that’s the route you want to take if market impact is a concern. Orders placed before open below the previous close for a buy or above the previous close for a sell are more likely to be filled than the same orders placed shortly after open because of the way opening prices are calculated and the high price volatility in the first few minutes of trading. On the other hand, those prices might not be as good as what you’d get later in the day if the price moves in your favor.
What I do now is this. If I can place a VWAP limit order, I’ll do so shortly before or after market open. If I can’t—if I’m trading too few shares or if I’m trading an over-the-counter stock—I’ll place a limit order prior to market open not too far from yesterday’s close for a portion of the shares I want to buy, and then place further orders throughout the day. And if the price moves drastically away from me, I’ll abandon the order.
This isn’t brilliant or foolproof, and I’m sure there are plenty of other good ways to place orders. One investor I know swears by the Fox River VWAP algorithm at Interactive Brokers, and says that it has dramatically reduced his trading costs.
4. Persistence of growth is chimerical.
Verdad Capital published an excellent piece this year that proved that companies that have grown in the past are not much more likely to grow in the future than companies that haven’t. Past growth is not really indicative of future growth. If you want to estimate future growth, using past numbers is often going to give you garbage.
There are other ways to predict growth besides looking at past numbers. I’ve written about this before, but I had never seen such a good outside study about it until 2022.
5. Volatility matters when measuring market impact.
I have made many attempts to measure market impact over the years, and it was only late last year that I started taking volatility into account. Before that I was relying primarily on the amount you trade divided by the typical daily volume, which has a nice correlation to market impact. Volatility alone has a significantly lower correlation than that measure. But if you couple the two measures, you get a much better model for market impact than if you leave volatility out. I experimented extensively with this, comparing my fills with the price before placing the order, and was pleasantly surprised by how much volatility matters.
If σ is volatility, a is the amount you trade, and v is the daily volume, then the general formula for market impact is pσq(a/d)r, where p, q, and r are constants. In my experience, q is pretty close to 1 and r is pretty close to 0.5; p depends on how you measure σ, but I use 0.625.
6. Financial schadenfreude can be great fun.
Prior to 2022, I’d never really experienced financial schadenfreude. (Schadenfreude is rejoicing in other’s misfortunes.) But 2022 was a wonderful year for it, since we witnessed the financial self-destruction of three of the most annoying and self-promoting billionaires: Elon Musk, Sam Bankman-Fried, and Mark Zuckerberg. Musk offered to buy Twitter, then changed his mind, then was forced to buy it anyway, and has been destroying its remaining value ever since. Bankman-Fried was shown to be a fraudster on the level of Bernie Madoff, though far less competent. And Mark Zuckerberg changed the name of his company and decided to switch its primary focus to what he calls virtual reality but is actually no more than headset technology, throwing billions of dollars at it with nothing to show for it, since most people don’t use headsets, and most people won’t use headsets.
7. How private foundations work.
In late 2021 I started a private foundation, and I’ve since learned a lot more about how they work.
Let’s say you want to give a lot of money to charitable causes and institutions, and you want to be able to have a good deal of say over that giving. I’ve always done this from my cash account with monthly donations. But starting a private foundation offers some major perks.
First, donations to the foundation are deductible from your taxes up to 30% of your adjusted gross income. This is, I admit, a lower limit than simpler charitable donations, but there’s a singular advantage to the private foundation. And that is that you can grow the money in the foundation account almost tax free. Investment income is taxed at a rate between 1% and 2%.
The foundation will cost you a small amount every year in taxes and fees, but probably less than 3% of its assets. Even if your tax rate times your return on investment is very small, a foundation may be a good idea. If you’re giving less than 30% of your AGR, then putting the extra in a foundation will still save you a good deal on your personal income taxes.
I knew most of this in 2021, but in 2022 I learned more about how the actual charitable donations are processed—in particular, how to give money to foreign charities. If you dig deep enough, you can usually find a US branch that will accept the donation and then transfer it to the foreign charity. For example, to give to Armonia Bolivia in the US, you instead give to the Bird Endowment and specify that your funds are to be used at Armonia's discretion. If no US branch exists, it can be very expensive and complicated to give to foreign charities. The details are beyond the scope of this article, but suffice it to say that US tax law does not make it easy.
I use Foundation Source to manage my foundation, and they’ve been serving me very well. They make it easy to file the paperwork, process the donations, pay the IRS, and investigate foreign charities. The Foundation account is set up at Fidelity, and I can use margin and invest in whatever I want. It’s been a great way to involve my wife and kids, who direct the Foundation with me, in charitable giving.
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