Last time we reviewed the advantages of index funds and introduced the concept that different stocks may have different attributes (called “factors”) which lead to different returns. This time, we will specify the four primary factors identified in the research and look at the differences they make to returns. Then we will discuss some drawbacks or things to be aware of when incorporating factors into your portfolio. You should come away with a better understanding of factors and how they may, or may not, fit into your portfolio.
Research has revealed four primary factors that are both pervasive (widespread across assets classes and different markets) and persistent (observed throughout time). They are: Value, Size, Quality, and Momentum. Let take a look at each.
The Value Factor: This factor says that low-priced stocks (value stocks) have returned more than high-priced stocks (growth stocks) over time. And this makes intuitive sense; after all one of the cardinal rules of investing is to ‘Buy Low and Sell High.’ Since 1926, Large value stocks have outperformed Large Growth stocks by 1.4% annualized. Within the small-cap space, the difference is even greater with the gap coming it at 4.8%.
The Size Factor: The size factor says that small company stocks have returned more than large company stocks over time. Again, this one is fairly intuitive as small companies are generally riskier than their larger counterparts, but with greater growth potential. Again using the Fama/French data back to 1926 shows this factor has led to an increased return of nearly 2% annually over the last ninety years.
The Quality (Profitability) Factor: The quality factor says that companies with high quality fundamentals (typically high profitability) outperform low-quality firms over time. Again, this one makes sense—given a similar price it would make sense that a company with high profitability relative to the rest of the companies in the market would make a better investment over time. A large part of the outperformance simply comes from avoiding the low profitability firms. As author Larry Swedroe recently wrote,
“The majority of the profitability premium is derived from the subsequent low returns of the low-profitability firms. This is consistent with the notion that overpricing is harder than underpricing for arbitrageurs to correct due to greater shorting impediments.”
For highly profitable large cap stocks, the outperformance versus low-profitability stocks has been 2.77% annually (back to 1963 when profitability data is first available). In small caps, the difference is even wider at 4.78% annually.
The Momentum Factor: Lastly, there is the momentum factor which says that stocks that have done well recently (high momentum) outperform in the short run (typically, less than a year) versus those that have done poorly recently (low momentum).
The momentum factor is usually explained to exist for a couple of reasons. One, there is evidence of momentum in company fundamentals (earnings, revenue, etc.) and prices are simply a reflection of this. The other explanation is behavioral. The markets tend to under or overreact to new information and in the short-run, the market prices are essentially catching up to the new information. Fund manager AQR defines momentum as follows:
Momentum is a phenomenon driven by investor behavior: slow reaction to new information; asymmetric responses to winning and losing investments; and the "bandwagon” effect.
And author Ben Carlson describes it this way:
“Research shows that investors hold onto losing stocks too long in hopes they will come back to their original price while selling their winners too early. Investors also anchor to recent results, so initially markets underreact to news, events or data releases. On the flip side, once things become apparent, investors herd and overreact, causing an overshoot in either direction. Fear, greed, overconfidence, and the confirmation bias can lead investors to pile into winning areas of the market after they’ve risen or pile out after they’ve fallen.”
Momentum, while more challenging and expensive to execute, has some of the strongest returns of all the factors. A 2014 study titled “Fact, Fiction and Momentum Investing” found that building a portfolio which goes long stocks with high momentum and shorting those with low momentum led to outperformance of between 6% and 8% depending on the period studied. A separate study, (this one studying momentum going back two centuries!) finds similar outperformance.
Source: Fact, Fiction and Momentum Investing (2014)
What’s the Catch?
So at this point, I hope you’re asking yourself “what’s the catch?” After all, there is no free lunch with investing. And you’re right--there is a catch: these factors don’t work all the time. They don’t work every day, month or even year. It takes discipline to stick with the strategy and a willingness to be different than the rest of the market to realize the incremental returns.
Think about it like this: casinos don't win every hand or role of the dice. They simply design the game where they have a slight edge, then play as many hands as possible. Over time, their edge reveals itself, and they make a fortune. Factor investing is the same. Design your portfolio to tilt toward the factors with higher returns, but then stick with it over a period of years and decades (i.e., play enough hands) so that the edge is revealed.
For example, let’s consider a value strategy during the 2000 tech bubble. This was a period in which even the great Warren Buffett was being ridiculed as being behind the times and having lost his touch. It was difficult to maintain a value strategy through this period but those who did so were well rewarded over the following years.
As with any investing strategy, the factors are not always going to work. The factors only "work" in roughly 60% to 70% of any one-year period. The odds are in your favor, but you can't expect it to work year-in and year-out. However, as your time period grows the probability of the factors working also increases. As with any investing strategy, discipline is the first rule to realizing returns.
Source: Dimensional Funds
Next, it's still important to keep costs low. For those looking to allocate towards these factors, it's important to keep expense ratio and turnover (reducing trading costs and taxes) as low as possible. Lastly, we prefer to allocate to factors in a disciplined, systematic way. Not based on human decision making.
As we’ve just seen, including proven factors can be a valuable addition to a portfolio strategy, but it does require a few things: costs must not be ignored, you need to understand what factors to include in your portfolio and how to do so, and lastly, one must be disciplined and commit to the strategy over time as the benefits of these factors aren’t going to show each and every year.
For clients, we go through these execution specifics in more detail and do the fund specific research on your behalf. If you’re not a client, but are a current or former Intel employee and want to know more about how to incorporate factor investing into your investment approach, please get in touch.
 Traditionally this is defined as low P/B (Price-to-Book), but P/E (Price-to-Earnings), P/S (Price-to-Sales) among others can be used with similar results.