Benjamin Graham and David Dodd introduced the world to value investing when they published their seminal book Security Analysis. In 1948, Richard Donchian introduced the world to momentum trading after he launched the first public futures fund and applied “trend following” (momentum trading) to a diversified portfolio of futures markets.
What is a Return Driver?
The Brandywine report referred to before mentions “A Return Driver is the primary underlying condition that drives the price of a market." When it is defined in this fashion, we realize that buying-and-holding stocks isn’t beta. It is simply another Return Driver based investment strategy – the Return Driver being the fact that over the longer-term (periods of 20 years or more) an increase in corporate earnings leads to an increase in stock prices. If you believe there should be an increase in earnings, buy stocks.
Value investing is simply the acknowledgment that over the long term, competition results in a leveling of profit margins among similar companies, so all else being equal, buying the “cheaper” stock today will produce greater returns than buying the “expensive” stock.
Once Fama and French uncovered value (and also the small cap effect) as being valid Return Drivers (they and other academics refer to them as “Risk Factors” under the misguided belief that returns are earned in exchange for assuming risk, which is seldom the case), the floodgates began to open for equity investors.
Over the past decade or so, academics have “discovered” numerous Return Drivers, including those based on dividends, volatility, illiquidity, and cash flow; and fund marketers have launched hundreds of smart beta mutual funds and ETFs designed to capture profits (for themselves at least!) by exploiting these Return Drivers.”
In the light of the concept of Return Driver, we can summarize:
o Beta describes strategies (such as buy-and-hold) that are based on Return Drivers that are widely exposed and accepted as being valid in the public domain.
o Smart Beta refers to Return Drivers that have been exposed but are not yet as widely employed or accepted in the public domain.
o Alpha is the term used to describe Return Drivers that are not yet widely disseminated or accepted in the public domain.