Several years ago, I had the privilege of attending a bacon cook-off at a restaurant in Brooklyn. Twenty-two dishes, labeled 1 through 22, graced the tables of the restaurant. Only one requirement: each dish had to use bacon as its main ingredient. Attendees, including yours truly, tasted all the dishes, and at the end we voted for our favorite dish. Whichever dish got the most votes got the prize and more importantly, the glory of knowing they cooked the best bacon dish this side of the East River.
Right from the start, Dish 1 was amazing. Perfectly succulent bacon, bursting in my mouth. My taste buds almost passing out with delight. I savored this peak moment in my day (read:my week) and moved on to the next dish. Dish 2 was good, but not quite as good as Dish 1. I stepped through the dishes, carefully evaluating each. Dish 10 was fine but sort of boring. Dish 17 wasn’t great. Dish 20 wasn’t impressive. My bites got smaller and smaller as I went. Dish 22 I barely ate. I think it was some sort of bacon ice cream.
All attendees proceeded as such, from Dish 1 to Dish 22 in that order, to keep a uniform flow throughout the restaurant. It was a lot of food. After you finished your tastings, you submitted your vote. I waited for the result, barely able to move. Soon it came: Dish 1 was the winner of the bacon cook-off. Congratulations! “Well deserved,” I thought. I loved Dish 1.
But wait, was Dish 1 really the best dish? There is something wrong with this picture. Let’s analyze this from a factor perspective. We will see at the end that being sloppy with factor exposures can result in incorrect performance attribution, and potentially even worse, bad cook-off results.
All twenty-two cook-off dishes had a common attribute: bacon. In investing, a common attribute shared among many securities is often called a “factor.” Value stocks share a common attribute, which is favorable valuation metrics (a high book-to-price ratio for example), and are said to “have exposure” to the “value factor.”1 High momentum stocks share a common characteristic as well -- they have all outperformed recently and therefore have exposure to the “momentum factor.”2 To use investing lingo then, all twenty-two cook-off dishes had positive exposure to... the bacon factor.
Thinking in terms of factors is helpful, because once a factor has been identified, its properties can be analyzed. In investing, typically the most important property to know about a factor is does it make money or not, and if so, how much money does it make and what are the risks? Do value stocks outperform, and if so, by how much, and what are the risks? 3
So what are the properties of the bacon factor? Firstly, we know that bacon is amazing, so we know that the bacon factor generates high excess returns for your taste buds and for your life overall. However, we also know another thing about the bacon factor, and all “food factors” in general, which is that they are subject to the law of diminishing marginal return. This simply means that the first bite is the best, and then each subsequent bite is not quite as good as the first bite. Eventually, the bites reach the territory of negative utility, and that’s typically when you stop eating.
Even bacon will reach this point: at some point, after you’ve eaten enough bacon, the thought of eating another bite will make you gag. The same is true in investing, by the way. The momentum factor might generate high excess returns, but if you “eat” too much of it -- say if you allocate 100% of your portfolio towards momentum for example -- your portfolio won’t exactly gag, but it will likely not be optimal and it will likely suffer from having too much momentum exposure, even if momentum is a great factor to be exposed to. This is just another way of saying “diversification is good”.
Let’s now bring our knowledge of the bacon factor to bear on the Brooklyn bacon cook-off.
Attendees tasted all the dishes in the same order: 1 through 22. But we know that the bacon factor has the property that the first bite is the best, and the utility of each subsequent bite drops off after that, eventually becoming negative. This gives a clear advantage to Dish 1, which is able to “get credit” for the best of the bacon factor. By the time the attendees get to Dish 22, they are sick of bacon, and the factor is likely paying negative returns at this point. Even a fantastic bacon dish isn’t going to taste all that great if it is Dish 22.
Ideally, the attendees themselves would account for diminishing utility in their votes, but this is not something humans can do easily… that first bite of bacon is just so good! Thus, the best solution is to neutralize the bacon factor from the beginning, so that dishes were only being rewarded for performance above and beyond the bacon factor.
The easiest way to do this is probably to have each attendee try the dishes in random order. That way, any individual attendee will still prefer the first dish over the last, but at least this bias is spread randomly across many dishes. This still opens up the possibility of one dish getting randomly selected as the first dish more than others, so we may want to explicitly give each attendee their own preset ordering that we’ve determined so that we can assure equality amongst dishes. Another, more humorous way, would be to have attendees eat a plate of “control bacon” before the contest started, so that the bacon factor would already be largely neutralized by the time they started on the first dish. This solution would still face the problem of diminishing marginal utility, but at least it would mitigate Dish 1 stealing the credit for those uniquely sublime first few bites of bacon.
The lesson here is that when comparing various items, you want to evaluate them on an even playing field: on an apples-to-apples, or bacon-to-bacon basis. For investors, this means that investments should be evaluated for performance in excess of well-known factors. The first step in any evaluation of managers or funds should be to strip out, or neutralize, all known factor exposure, and evaluate what’s called the “residual.”
This is especially important if factor performance has been strong. For example the U.S. equity market was up 31.5% in 2019.4 That’s about as tasty as the first bite of bacon, and it’s important to make sure that investments that had passively long equity exposure don’t get undue credit for upswing, in the same way we don’t want the first bacon dish to get credit for the tastiness of the first bite of bacon. If care isn’t taken to neutralize factor exposure in performance evaluation, incorrect comparisons can occur, and incorrect decisions are at risk of being made.
Somewhere in Brooklyn, there is a chef with an undeserved bacon cook-off trophy on their shelf. And somewhere else in Brooklyn, there is a crestfallen chef wondering why their Dish 22 didn’t get any votes. All because the organizers didn’t think in terms of the bacon factor.
1 Fama, E. F.; French, K. R. (1993). "Common risk factors in the returns on stocks and bonds". Journal of Financial Economics. 33: 3–56.
2 Jegadeesh, Narasimham, and Sheridan Titman (1993). “Returns to buying winners and selling losers: Implications for stock market efficiency”. Journal of Finance. 48, 65–91.
3 For additional reading on this topic, check out the blog post “Risk Without Return.” It discusses how to determine which risks in your portfolio you are getting paid to take and which you are taking without any compensation.
4 Source: Venn. The U.S. equity market is proxied by the S&P 500 Index.
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