I just updated the essay to include some more justification for (1) the claim that it’s possible to beat the market and (2) the specific return estimates given. I added the new material to the sections “Improving on conventional wisdom” and “Return expectations”, and have reproduced the latter below.
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As something of a corroboration, RAFI provides estimates of forward-looking five-year return for various long/short factors. At the time of this writing, it makes the following predictions for its long/short value and momentum factors (net of transaction costs):
5.7% for US large-cap value
1.1% for US large-cap momentum
8.0% for US small-cap value
6.4% for US small-cap momentum
(RAFI’s projections for foreign developed market factors are similar but generally a bit higher.)
A concentrated long-only portfolio on a particular factor would have approximately the same expected return as the long/short factor plus the broad market (although that’s not quite how the math works).
The underlying indexes used by VMOT make some improvements on RAFI’s simple factor model (see Quantitative Value and Quantitative Momentum for details[^26]), so it might be reasonable to assume a higher expected return for VMOT. If we then subtract fees, we get something close to the original estimate I gave for VMOT (probably a bit higher[^27]).
RAFI believes the value and momentum premia will work as well in the future as they have in the past, and AQR makes the same claim in some of the papers I linked above. They offer good support for this claim, but in the interest of conservatism, we could justifiably subtract a couple of percentage points from expected return to account for premium degradation.
Note that RAFI’s estimates use factor timing—attempting to guess how well factors will perform based on the current market environment, rather than just looking at historical behavior. This practice is not widely accepted; for example, see AQR’s Factor Timing is Deceptively Difficult.
Also note that these numbers only give expected mean return. Even if these estimates are accurate, we could still see much higher or lower returns due to market volatility.
I just updated the essay to include some more justification for (1) the claim that it’s possible to beat the market and (2) the specific return estimates given. I added the new material to the sections “Improving on conventional wisdom” and “Return expectations”, and have reproduced the latter below.
-------
As something of a corroboration, RAFI provides estimates of forward-looking five-year return for various long/short factors. At the time of this writing, it makes the following predictions for its long/short value and momentum factors (net of transaction costs):
5.7% for US large-cap value
1.1% for US large-cap momentum
8.0% for US small-cap value
6.4% for US small-cap momentum
(RAFI’s projections for foreign developed market factors are similar but generally a bit higher.)
A concentrated long-only portfolio on a particular factor would have approximately the same expected return as the long/short factor plus the broad market (although that’s not quite how the math works).
The underlying indexes used by VMOT make some improvements on RAFI’s simple factor model (see Quantitative Value and Quantitative Momentum for details[^26]), so it might be reasonable to assume a higher expected return for VMOT. If we then subtract fees, we get something close to the original estimate I gave for VMOT (probably a bit higher[^27]).
RAFI believes the value and momentum premia will work as well in the future as they have in the past, and AQR makes the same claim in some of the papers I linked above. They offer good support for this claim, but in the interest of conservatism, we could justifiably subtract a couple of percentage points from expected return to account for premium degradation.
Note that RAFI’s estimates use factor timing—attempting to guess how well factors will perform based on the current market environment, rather than just looking at historical behavior. This practice is not widely accepted; for example, see AQR’s Factor Timing is Deceptively Difficult.
Also note that these numbers only give expected mean return. Even if these estimates are accurate, we could still see much higher or lower returns due to market volatility.