An Introduction to Factor Investing
Should you tilt your portfolio toward factors?
This post, like last week's, is going to get a little wonky. It won’t be easily accessible or relevant for beginners, but I wanted to do a post explaining a more intermediate level of investing. This post is for those that want to understand factor investing and how it might help you achieve higher returns. If it’s too difficult to understand, no worries. You can skip it or come back to it when it becomes more relevant to you.
The efficient markets hypothesis says that stock prices reflect all available information and that investors can’t beat the market without taking on greater risk. One way to do that is through the idiosyncratic risk of individual stocks, but this doesn’t have a good track record for the average investor. Another method is by investing in factors, which academic research backs up.
Factors are characteristics that can explain why some stocks outperform the market. For example, the size of a stock is a well-known factor. So is value; if a stock is trading at a lower price relative to its earnings or book value, it may be considered undervalued.
Factors may provide a way to consistently outperform market-cap-weighted indexes without a traditional active manager or stock picking strategy. If you can implement a systematic strategy in your portfolio by overweighting specific, evidence-based factors, you may be able to give your portfolio an edge.
So what are the major factors, how were they discovered, and should you invest in them? To answer that, we need to understand the major asset pricing models for explaining returns.
The CAPM Model
The capital asset pricing model (CAPM), developed in 1964 by William Sharpe, prices assets based on their risk and identifies a factor known as market beta to explain stock returns. Beta measures the volatility of a stock in relation to the overall market, which would have a beta of 1. Stocks with a beta of greater than 1 would be more volatile — or riskier — than the market, and stocks with a beta of less than 1 would be less risky than the market.
The CAPM became a foundational model for understanding asset prices and expected returns. But it was considered too simplistic and only explained 70% of the difference in portfolio returns. In particular, it couldn’t explain some anomalies in stock returns, namely why small stocks and undervalued stocks outperformed.
The Three-Factor Model
Academic research throughout the 1980s showed that small stocks outperformed large stocks and stocks with lower valuations relative to price outperformed stocks with higher valuations. Rolf Banz discovered the size effect in 1981, while Barr Rosenberg, Kenneth Reid and Ronald Lanstein identified the outperformance of value stocks in 1985. This mattered because the higher returns of active funds were often attributed to manager skill. But if these managers were simply overweighting small and value stocks, their use of factors, and not skill, could explain their outperformance.
In their 1992 paper titled “The Cross-Section of Expected Stock Returns,” economists Eugene Fama and Kenneth French identify these two factors, which they named high minus low (HML) and small minus big (SMB), as responsible for much of the outperformance in portfolios.
Fama and French combined the market beta factor with the size and value factors to create the now famous three-factor model, which explained 90% of the difference between portfolio returns.
Did this model mean the market was inefficient? No. Fama and French concluded that small and value stocks were riskier, and investors willing to take these risks would be compensated with a premium, or additional return explained by these factors.
The Five-Factor Model
In 2014, Fama and French expanded their three-factor model by adding two more factors: profitability and investment.
The profitability factor showed that more profitable companies outperformed less profitable companies, a factor called robust minus weak (RMW) in the model. Previously discovered by Robert Novy-Marx, the profitability factor helped explain why small-cap growth stocks underperformed and dragged down the universe of small-cap stocks. Investors could improve their returns by removing unprofitable small-cap growth stocks and only investing in small-cap value stocks.
The investment factor explains that companies with more conservative investment strategies outperform companies with more aggressive investment strategies. In the model, this is called conservative minus aggressive (CMA).
This five-factor model could explain 95% of the difference in portfolio returns.
How to Implement Factor Investing
These factor models only scratch the surface. Research has identified hundreds of factors, although the evidence supporting them varies. Likewise, there are more models that attempt to explain the outperformance of various portfolios. But the three and five-factor models remain the most popular for explaining outperformance.
To review, these are the five factors:
Beta
Size
Value
Profitability
Investment
For factors to be worth paying attention to, they should be persistent over time, meaning they show up at various periods throughout history, and pervasive, meaning they appear in stock markets around the world. You wouldn’t want to invest in a factor that only appeared during one decade in the past or one country’s stock market.
To be a factor investor, you have to be comfortable with greater volatility and longer periods of underperformance. We’ve seen such a period recently since the 2008 financial crisis as large growth stocks like Amazon, Tesla and Apple have soared and sectors traditionally associated with value, such as gas, energy and financials, have suffered. But according to academic research, we should expect factor premiums to pay off over long periods.
The Fama-French factors expose you to different types of risk than a market-cap-weighted portfolio alone. If you can stomach greater volatility in your portfolio, exposure to these factors can offer higher expected returns. They may also offer more reliable returns over time. When the market factor suffers, any one or more of the other four factors can outperform.
The trick is knowing how to effectively capture these factor premiums. You can do so through funds that track a small value index, like the Vanguard Small-Cap Value ETF (VBR) which comes with a low expense ratio of 0.07%.
But simply tracking a static index may not adequately capture factor premiums. Instead, you need funds with a more active screening process for factors.
Unlike index funds that attempt to capture the small value premium, these funds offer improved screening for size, value and profitability. This allows funds to remove stocks that are undervalued because they’re poor-quality companies. While not passive in the sense of an index fund, these funds are also not quite active. Active management purports to bring manager skills to the table, whereas factor funds use a rules-based quantitative process for identifying stocks.
You can combine factor funds with market-cap-weighted index funds to tilt a portfolio toward small and value stocks. In this strategy, you maintain a core position of market-cap-weighted index funds — such as those from Vanguard. Then, you allocate a satellite portion of your portfolio to factor funds.
For years, Dimensional Fund Advisors was at the cutting edge of factor investing. But in 2019, another company composed of former Dimensional employees called Avantis Investors emerged offering factor funds at a lower cost and in ETF form, making them accessible for the average investor.
Avantis funds, while more expensive than index funds, are still relatively low-cost. The Avantis U.S. Small Cap Value ETF (AVUV) comes with an expense ratio of 0.25%, while the Avantis International Small Cap Value ETF (AVDV) and Avantis Emerging Markets Value ETF (AVES) come with an expense ratio of 0.36%. These three ETFs give you global exposure to factor premiums, just like Vanguard’s total U.S. and total international stock market index funds give you global exposure to the market factor.
Combining Vanguard index funds with Avantis factor funds with a somewhat aggressive tilt of 25% might look something like this:
VTI - 55%
VXUS - 20%
AVUV - 15%
AVDV - 5%
AVES - 5%
Should You Invest in Factors?
Because factor tilting is a more aggressive strategy that potentially introduces more volatility to a portfolio, it’s best for younger investors who have time to recover from periods of underperformance.
A lot of investment products are marketed with the term “smart beta,” which essentially refers to factor investing. But some of these products may not be tracking the factors you want. Before investing in a factor fund, understand what factors the fund is trying to capture. And don’t invest too much of your portfolio in factors.
Factor investing isn’t necessary for a secure retirement, and it’s still hard to beat the simplicity of index funds. But investors who wish to go beyond a market-cap-weighted portfolio and understand the risks may gain higher performance by investing in factors.