The Bacon Factor

The Bacon Factor

Several years ago, the author 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 tasted all the dishes, and at the end voted for their favorite dish. Whichever dish received the most votes earned the prize.

Right from the start, Dish 1 was exceptional. Perfectly succulent bacon. Dish 2 was good, but not quite as good as Dish 1. Dish 10 was fine but unremarkable. Dish 17 was not great. Dish 20 was not impressive. Dish 22 was barely touched. It appeared to be some sort of bacon ice cream.

All attendees proceeded in the same order: 1 through 22, to keep uniform flow throughout the restaurant. After finishing their tastings, attendees submitted their votes. The result: Dish 1 won the bacon cook-off.

Whether Dish 1 was truly the best dish is worth examining. Being imprecise with factor exposures can result in incorrect performance attribution and, potentially, flawed conclusions.

All twenty-two cook-off dishes shared 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 terminology, all twenty-two cook-off dishes had positive exposure to the bacon factor.

Thinking in terms of factors is useful, because once a factor has been identified, its properties can be analyzed. In investing, the most important property to understand about a factor is whether it generates returns, and if so, how much and at what level of risk.³

The bacon factor generates high excess returns for the palate. However, all “food factors” share another well-known property: they are subject to the law of diminishing marginal return. The first bite is the best, and each subsequent bite is slightly less satisfying. Eventually, additional bites reach the territory of negative utility.

Even bacon will reach this point: after sufficient consumption, the thought of another bite becomes unappealing. The same is true in investing. The momentum factor may generate high excess returns, but allocating 100% of a portfolio to momentum will likely result in a suboptimal outcome with excessive factor concentration. This is another way of saying that diversification is beneficial.

Returning to the Brooklyn bacon cook-off: all attendees tasted dishes in the same order, from 1 through 22. Because the bacon factor carries the property that the first bite is the best, and utility declines with each subsequent serving, Dish 1 received the full benefit of that first-bite premium. By the time attendees reached Dish 22, the factor was likely contributing negative returns. Even an excellent bacon dish would not perform well in that position.

Ideally, attendees would account for diminishing utility in their votes. The easiest corrective approach would be to have each attendee taste dishes in a different randomized order, spreading the first-bite advantage across all dishes. A more explicit solution would be to pre-assign orderings to ensure distributional equality. Another approach would be to have attendees consume a “control” serving of bacon before the contest, largely neutralizing the factor before evaluation began.

The lesson is that when comparing various items, evaluation should occur on an even playing field: on a bacon-to-bacon basis. For investors, this means investments should be evaluated for performance in excess of well-known factors. The first step in any evaluation of managers or funds is to strip out, or neutralize, all known factor exposure and evaluate the residual.

This is especially important when factor performance has been strong. For example, the U.S. equity market returned 31.5% in 2019.⁴ Investments with passively long equity exposure should not receive undue credit for that performance, in the same way that Dish 1 should not receive credit for the first-bite premium of the bacon factor. When factor exposure is not neutralized in performance evaluation, incorrect comparisons occur and flawed decisions may follow.

Somewhere in Brooklyn, there is a chef with an undeserved cook-off trophy on a shelf. Somewhere else, a chef wonders why Dish 22 did not receive any votes. The outcome was determined not by culinary merit, but by uncontrolled factor exposure.

Contact Solovis to learn more or request a demo

References

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, see the related blog post “Risk Without Return,” which discusses how to determine which risks in a portfolio are compensated and which are not.

⁴ Source: Solovis. The U.S. equity market is proxied by the S&P 500 Index.