Our advanced book for the 2017 Continuing Financial Education week is brought to us by Andrew Berkin and Larry Swedroe. Your Complete Guide to Factor-Based Investing has been on my list all year. Of the books I reviewed this week, it's the only one I actually purchased and really, aside from the history books, the only one I really wanted to read. I mean, let's be honest. I have little interest in reading a book about physician-specific personal finance. I wrote the book on that topic. I write about it several times a week, do a podcast about it etc. The likelihood of me finding something I can use in a book like that is pretty low. And if it wasn't, I'll get another one in the mail next month. But this book, this book promised to teach me something I wanted to know.
Factor-Based Investing and Portfolio Diversification
So what did I think the book could teach me? The answer to this question:
What should I do with all these fancy new factors like momentum, quality, and profitability? Should I incorporate them into my portfolio or not and if so, how?
If that question made zero sense to you, don't worry. As I mentioned above, this is an advanced topic. You see, some people advocate that you diversify within an asset class, using an index fund for example. It is also generally taught to diversify between asset classes, some in stocks and some in bonds and some in real estate. Those asset classes get subdivided into large growth stocks and small value stocks and international stocks and multi-family and commercial etc. But there is an entirely different way to look at diversification. That is to diversify into “factors.” Academics love this stuff. They've found 600+ factors out there that they use to try to explain stock market performance, and they haven't even really gone after other asset classes yet. Snooty quantitative mutual fund companies like DFA, Bridgeway, and AQR love this stuff too, as do the advisors who sell access to those advisor-only funds. But the DIY investor is left wondering- am I missing out? Should I change my portfolio to reflect all this research that is coming out in the last decade about factors? Am I getting sub-par returns because I'm not paying a DFA advisor 1% a year to get me into these awesome funds?
Enter Andrew Berkin, Larry Swedroe, and Cliff Asness. Cliff, who works for AQR, wrote the foreword (did a nice job actually, that's probably the best part of the book.) Andrew Berkin works for Bridgeway. Larry Swedroe is the foremost DFA advocate on the planet when it comes to the popular investing literature, although he works as the chief investment guru for Buckingham and the BAM alliance of financial advisors. Given that background, you won't be surprised to see these guys are all huge advocates for factor investing. But even so, they do a pretty good job in the book pointing out issues with it. But first, let's point out some of the problems with the book.
Some Issues With Your Complete Guide to Factor-Based Investing
In the words of WCI columnist Whitney– “That cover sucks.” She's right. Look at it. The subtitle of the book is “The Way Smart Money Invests Today.” That presentation on the cover is apparently really, really boring. Good investing is usually boring investing though, so we had a nice discussion about how it is important not to judge a book by its cover. Unfortunately, the rest of the book is just as boring as the cover. I've read a half-dozen of Swedroe's books and my impression after reading this one is that Larry didn't write this. I think he lent his name to Andrew to put on the cover. I mean, I have no doubt he agrees with the ideas in it and did plenty of work, but it doesn't feel like his writing to me. It's a real slog to get through the book.
Each chapter is mostly just statistics and numbers being thrown at the reader and short descriptions of academic studies one after another. Let's put it this way- you won't have trouble putting this book down because it will naturally fall out of your hands when you nod off. As long as we're criticizing, let's talk about the layout of the book. The first half is chapters. The second half is appendices. But if you thought you could quit reading when you got to the appendices, you've got another thing coming. A big chunk of the most useful information in the book is in the appendices, including the real conclusions and recommendations of the book.
The Factors
Those shallow criticisms out of the way, I'm glad I read the book. It did answer the questions I was looking to get answered. It led to a great discussion with my wife about whether or not we want to add momentum to our portfolio. I like that the authors take a stand, like Swedroe did in his alternative investments book–these are the factors to pay attention to and these are the ones to ignore. I like that they start at the historical beginning and work their way through.
Beta
This factor represents the return you get for investing in the market (stocks) instead of a riskless asset like treasury bills. It turns out that the mix of Beta to riskless assets (i.e. stock:bond ratio) determines about 70% of your portfolio return. Academics have known about this for a long, long time and those of us who invest know that higher risk generally correlates with higher long-term return, at least expected return.
Small and Value
The next two factors the book hits are those that were added to Beta by Fama and French way back in 1992. I incorporated those into my portfolio when I first designed it more than a decade ago, so they're not new to me. The idea is that small value stocks have higher expected returns than the rest of the market because of both risk reasons and behavioral reasons. Together with beta, this three factor model explains 90% of portfolio return. Anyone who's read any Swedroe, Ferri, or Bernstein at all is likely familiar with these factors.
Momentum
The next factor in the book, as well as in history, popped up in about 1997. This is basically the idea that stocks have momentum, that is the ones that have done well in the recent past will continue to do well in the near future. Why? Well, nobody really knows. It just happens. But the academics put forth two explanations- the first behavioral, basically a herd effect, and the second risk-based, because when momentum crashes it crashes hard! Despite those terrible crashes though, investing preferentially in stocks with momentum, at least when viewed through the retrospectoscope, have led to higher returns. The really interesting thing about momentum though is that it appears to be the best factor. Better than Beta. Better than Value. Certainly better than Small (which may be the least meaningful of the factors at least based on past data.) Adding momentum to the three-factor model apparently explains 95% of portfolio return. But where oh where could that last 5% be coming from?
Profitability and Quality
These two factors were lumped together into their own chapter in the book. I've been hearing this term quality thrown about for years but never really had the definition on the tip of my tongue. Profitability though is relatively easy to define. There are lots of different ways to measure it, but the best is probably gross profitability- that is the total profit of the company divided by the capitalization of the company. Although you would think profitability would be priced in a relatively efficient market, apparently, preferentially investing in profitable stocks leads to a premium. This one really hit the academic literature in 2013. I mean, I've been blogging longer than that. It's a baby as factors go (and most are even newer!) So I don't know how much faith to put in it.
Even after reading the chapter on quality, I still can't define it without going back to the book. So I'll just quote it:
High quality companies have the following traits: low earnings volatility, high margins, high asset turnover, low financial leverage, low operating leverage, and low stock-specific risk.
Okay, that all sounds good, I agree. But why that isn't priced into a company's price is beyond me. I mean, that sounds to me like exactly what an actively managed mutual fund manager should be interested in, so they ought to bid up the price of these companies until the return from them is equal to that of a low-quality company. But apparently they don't, so it's a factor.
Comparing Stock Factors
The best page (page 133) in the book is at the end of the Profitability/Quality Chapter. I reproduce the ‘money” table here:
Let's spend just a moment on here to explain it. Across the top are the factors- MB is just beta. Down the left side are the good things you want and bigger is always better. So if we look at Beta, if you invest in stocks instead of 30-day treasury bills, historically that has given you 8.3% better returns. Seems like a great reason to invest in stocks, right? The Sharpe ratio is a measurement of risk-adjusted return. It's the average return minus the risk-free return divided by the standard deviation of return on an investment. It's really only useful when comparing one ratio to another. Its absolute value doesn't mean much. But as you can see, the Sharpe ratio in the chart is momentum. In other words, you're better off taking momentum risk than stock risk, especially when you consider that the premium is larger and the odds of outperformance are higher, at least in the past. But the bottom line of the chart is that all the factors contribute something, but if you had to rank them, it's momentum first, then market risk, then value/profitability/quality (which all seem pretty related to me), and finally size. These are clearly the stock factors that Berkin and Swedroe think are worthwhile, although based on Asness's foreword, it sounds like there is still plenty of controversy even here.
Other Factors
But at this point, you're only halfway through the book. There's a chapter on bond factors. Basically, the authors think taking term risk is rewarded but taking default/credit risk is not.
There's also a chapter on the “carry” factor. Carry is most commonly thought about when trading currencies. Basically, if you live in Japan where interest rates are crap, you send your money to Australia where interest rates are higher. As long as inflation is similar in the two locations, and the exchange rate on the currencies doesn't change too much, you come out ahead. But apparently, the carry factor can also be applied to stocks, bonds, and commodities as well, with actually pretty good sharp ratios and odds of outperformance (better than all the stock factors in the chart above.) That said, there seems to be a pretty good risk explanation for this. The authors describe carry as:
Carry can be like picking up nickels in front of a steamroller. It has been profitable over the long term, but one must be sure they can handle being run over every so often.
Sounds a lot like momentum I suppose. The authors give both a behavioral and risk-based explanation for why carry exists. As near as I can tell, the author's only suggestion for how to implement it in your portfolio is by buying AQR funds.
The appendices of the book list a bunch of other factors which the authors think are not worth tilting a portfolio toward. No Swedroe aficionado will be surprised to find an entire appendix railing against dividends. They're not a factor. Never were. And dividend-paying stocks certainly don't take the place of bonds. If you still don't believe that, this chapter is worth the cost of the book.
There's another appendix on the “low-volatility” or “low-beta” factor. The authors cite a 2016 study, among other evidence, showing it's a crummy factor. If these guys who think factors are the cat's meow don't like a factor, I'm certainly not interested.
Factor Investing Implementation Advice
There's a lot of other great stuff in the book. This includes the shortest appendix (G) which points out that adding more factors to your portfolio can be counterproductive. You don't get the full premium for each new factor, plus you may increase turnover, raising trading costs and reducing tax efficiency. Not to mention, you reduce diversification among securities. So maybe don't try to add 10 factors. We've already got three, but we're at least thinking about one more.
There's also a great chapter on the biggest risk with factor investing- tracking risk. The more of your portfolio you have tilted toward all these factors, the less it is going to perform like the S&P 500 and your friend's portfolios, which might make it hard to stay the course for the decades it might take for these factors to pay off.
A related issue I think about a lot with regards to tilting, is that you've got to be a real believer in order to reduce your diversification (at least traditional diversification into more securities) and increase your costs to chase these factors. Believing is a big part of it. It will take a real commitment to these factors to stick with them when they're not paying off year after year after year. Given that the dataset on which they are based is almost entirely retrospective and limited to just 3 or 4 independent 30 year periods, it's hard to develop the kind of faith required to stay the course for long. Don't tilt more than your faith will support. It might be evidence-based investing, but the evidence is a far cry from a 5,000 participant randomized, placebo-controlled trial.
Perhaps the best part of the book is one of the last appendices where they provide a list of mutual funds and ETFs that can give you exposure to these factors. You find lots of funds like Vanguard Total Stock Market Index Fund for Beta and DFA US Small Cap Value like you expect. But when you get to momentum- there are only two listed- an AQR fund and iShares ETF. For Profitability/Quality in US stocks, there's just one recommendation- an iShares ETF. That's a heck of a long book to come down to “buy these funds” in the end. The alternative, as they explain, is to buy multi-style funds, a la DFA and AQR, where they magically bake all of these factors into a single fund. So really, that's the recommendation of the book- go hire a financial advisor who has access to DFA and AQR funds.
The problem with that sort of advice is that sometimes we DIY investors find little ways to invest in DFA funds, such as my ongoing experiment in my kids' Utah 529s where I've been running the Vanguard and DFA small value funds head to head for the last four years. So far, Vanguard is ahead by 2.4% a year, and that's excluding a typical 1% advisor fee for a DFA advisor. Granted, it's only been four years and granted, the last four years haven't been all that kind to a small value strategy and DFA's fund is smaller and more valuey than Vanguard's. But it does give you pause before you jump on the DFA wagon, especially when you consider that small and value is where the historical DFA difference seems to be largest. But like I've said for a long time, if you're going to pay for investment management, you might as well get someone with access to these funds.
Should You Read Your Complete Guide to Factor-Based Investing?
In the end, if you're an advanced investor who has been wondering about whether and how to implement these newer factors into your portfolio, you'll find this book to have some limited utility. Berkin and Swedroe have done an admirable job compiling all of this information into one place so you can make a decision about whether you're going to make any portfolio changes due to the information. Unfortunately, unless you're willing to go hire an investment manager, you simply don't have access to most of the recommended tools to implement these newer factors into your portfolio. As for me and my house, we'll likely spend a few months or years thinking about adding that iShares momentum ETF to our plan, but that's about it.
Buy Your Complete Guide to Factor-Based Investing Today!
What do you think? Have you read the book? What did you like about it? Do you tilt your portfolio? Do you use factors other than beta, small, and value? What has your experience been like? Comment below!
WCI,
Thanks for the review. I read this book last year and agree 100%. There’s a lot of data that’s presented and it really gets into the weeds. I reached the same conclusions that the only access to these factors were through companies like DFA which charge fees beyond what you can do on your own via Vanguard. I even brought this up to my DFA advisor who controlled one of my Roth accounts and had fees of less than 30 basis points. I tilt my own non-retirement portfolio (small, value, etc.) and have compared it to the DFA funds over the past 7 years. Like you, I have had disappointing results. I am better off doing things on my own. I have converted all of my Roth IRAs to Vanguard and am happy.
Jim: Wonderful review! I read this back in April. I love this stuff but found the book difficult to get through. Thanks for validating this!
I have been a DFA approved advisor for almost 10 years and I have struggled with whether factor tilts are superior to cap weighted indexes, especially when applying a 1% fee “factor” (or higher mutual fund fee DFA Core 2 vs. Vanguard Total Stock Index). A look at the DFA Matrix book and the heavily tilted Dimensional US Adjusted Market Index 2 (1928-2016) outperforms the CRSP 1-10 (1926-2016) by 1.3% barely covering fees.
In my practice, I charge hourly fees and try to keep fees below .25% of total assets that I advise on. I will use DFA funds for younger clients, but I have moved to cap weighted for retirees. Simply because they have less time to let factors work.
Michael, I’m not sure that’s the right way to look at it “because they have less time to let factors work”. Because we don’t know which factor (including beta) will be the best performer in even the near future, by diversifying across many of them, we increase the probability of the optimal outcome. Eg, beta only investors got creamed from 2000-2002, so someone who retired in 2000 would have been glad to have a tilt to small value stocks at that time.
Good point Grant. I admit my comment was somewhat simplified. I do implement systems to manage portfolio and sequence of returns risk for clients approaching and in retirement. Part of which is making sure that the client has 0 equity risk in their portfolio for funds they will need over the next 12 years. Even with that, I still stay with a cap weighted global equity portfolio. That gives the client exposure to all sectors without overweighting in a factor that may not pay off in the finite period that is a clients retirement.
0 equity risk for ten years. That seems awfully conservative. At a 4% WR, that’s a maximum of 52% equity.
I would say conservative, but for managing most retirees nest eggs the frame of reference needs to change from ROI: Return On Investment to ROI: Reliability of income*.
A portfolio with too high an equity percentage and a high withdrawal rate is at high risk of exposure to sequence of return risk.
Every client has their own circumstances. I will work with MoneyGuidePro’s Monte Carlo feature to get the client to a safe withdrawal rate (below 4%). The portfolio to manage that usually is around 50 or 60% equities. If it is more than that, I work with them to make changes to other variables (age to retire, current saving, future spending goals).
From that point, I will look at the future cash flows and develop a bucket strategy which aligns investments with the time frame they will be used. Generally, the portfolio ends up looking like a typical 50-60% equity mix (less if the client is at less than 3% withdrawal rate).
But, this becomes a great behavioral management tool to keep a retiree from panicking. The equity portion is always funds they don’t need to access for 12 years. This also allows the equity risk premium to hopefully do its thing.
Conservative yes, but in the end, for retirees, I don’t want to depend on investment magic to achieve unrealistic goals. Sometimes the goals need to change.
* ROI vs ROI is attributed to a speaker at Investment News 2017 Retirement Income Summit. Wish I had the name to credit.
Oh, are we only talking about retirees? All of a sudden 52% seems a lot more reasonable.
Yes, the thread went down a road when I stated I move retirees to cap weighted because they have less time to wait out the risks involved with factors.
A global cap weighted doesn’t mean you don’t have exposure to the other factors, it just means you are “tilting”or weighting towards those factors.
Correction: “A global cap weighted doesn’t mean you don’t have exposure to the other factors, it just means you are NOT “tilting”or weighting towards those factors.
Michael, my point is that if you have your clients only in a market (beta) portfolio, you are overweighting (in fact going all in) on that one factor. What if it’s that factor that underperforms in the near future?
Curious as to why you feel you need or have your retired clients with zero equity risk for as long as 12 years. Wasn’t the longest period from peak to full recovery since 1926, inflation adjusted with dividends reinvested, just 8 years from 1937 to 1945?
What if it turns out factors don’t exist going forward? That they were all just a product of backtesting and as soon as they became discovered and investable, they went away? The issue with factor investing is you have to decide what the odds of that happening are and invest accordingly. Maybe beta is the only factor that’s real in the end. It really is quite a dilemma.
True, that’s the faith part of it. For that matter, there’s no guarantee that the beta factor will persist as bizarre as that sounds. But given the data we do have, along with the risk and behavioural explanations, presence in all markets etc., it’s a pretty good bet, at least for the main factors.
Grant: As I stated in a response above: a global cap weighted doesn’t mean you don’t have exposure to the other factors, it just means you are not “tilting”or weighting towards those factors.
I also have looked at the performance of DFA’s long term US tilted indexes that they have built and the long term benefit is not huge.
An individual investor can do what they are comfortable with. I feel I have to be more cautious when advising people.
This whole discussion will have me playing with the DFA Returns software for hours. But not until after I watch my Buffalo Bills lose to KC!
Michael, no I disagree. A market portfolio has value and small cap stocks but does not access the value and size premium. For that you need to overweight value, small. Growth stocks cancel out value stocks. For the the full value premium you need to be long value stocks and short growth stocks, but a reasonable compromise is to just to overweight value. That’s the gospel according to Larry Swedroe.
no magic to beat the mkts long term
stick with vanguard all the way
I’m slightly confused. How is momentum any different that trying to time the market?
Every factor is trying to time segments of the market, which includes Beta or Market-Cap. Every factor has a rule or rules that say when to buy and/or sell a stock. When a stock gets too small for a S&P 500 fund like VFINX, it sells that position, or “times the market” with that position based on it’s rules regarding Market-Cap.
As an investor, you need to find which factors and/or strategies you believe in and can stick to over the course of your life. That’s it. If momentum makes no sense to you, ignore it.
I read the book when it came out and enjoyed it very much (I am a bit biased as I am a fan of factor investing and have been for a while).
In addition to Beta or Market exposure, which we all get in some fashion, I favor Value and *both* Momentums (I have a slight Size tilt due to my allocation but do not expect anything from it) in my portfolio and have ignored the other factors such as Quality (Research has shown that you get this passively from most mixed-value sorts anyways), Low-Vol, etc. I split my equity exposure 40/60 between Momentum and Value.
I have read many books on factor investing, but more importantly have tested many things from MSCI Benchmark data and the Fama/French Benchmark data, using both U.S. and International data. The testing I did myself along with the story behind the factors, was the basis for my change to a factor-based portfolio a number of years ago. I do not plan on going back, but I will caution that one should DO their own research before making any portfolio changes. It is one thing to read about factor research, but in my experience, trying to reproduce it and seeing how it works through different periods in history (Value during the depression, Value in the late 90s, Momentum crashes, etc.) from your own spreadsheet, really gives that final piece of conviction needed to make a lasting portfolio change.
I agree conviction is pretty important. I would caution you against using the present tense “works” and use “worked” instead, since you really have no idea whether it will work going forward or not.
Good catch. “Works” comes from my belief in the factor moving forward and is used as a personal word in that sense, but “worked” is the appropriate language for looking at these factors historically. There is no guarantee whatsoever that these factors will continue to “work” in the future. I understand I am taking a gamble on them, which is why I always stress the importance of belief in any investment decision one makes (Do your own research!). There is no guarantee in any stock investment, including Beta, just probabilities, hope and faith =)
Because it is a systematic automatic thing. The fund is simply buying what has done well in the recent past then in a few months, swapping those out for what has done well in the recent past over and over. Since stocks exhibit momentum, there is a premium there.
Market timing is “I think the market is going to go down, so I’m going to cash.”
I think momentum has been around a long time. It explains a lot of the dot.com rise and implosion. I think it is the volume being traded for one thing. Investors Business Daily is really devoted to momentum. “don’t fight the tape”.
I love fine tinkering with my porfolio, but I’m not sure momentum is worth the energy. Perhaps I’ll have to read the book for this answer, but is it worth only putting a slice of your investing into momentum, i.e. how much of your portfolio do you need to put into it to see a difference vs a total market strategy? I mean, I already own all of those stocks in MTUM. Two of the top ten in MTUM are also in top ten of total market (can’t say the same about small cap, which I am tilted towards).
Also, I don’t care enough to look into the methodology of MTUM, but that fund doesn’t own AMZN or NFLX. I don’t know, but companies that have returned 1000% and 6000% over 10 years with a straight line up kind of seem like the definition of momentum. Perhaps the better purchase for momentum would be bitcoin?
Although it gives me serious pause given the WCI is considering it, I intend to pass.
It’s a tilt, just like small value. With a small value tilt, you put a little more than market weight into small value stocks. With a momentum tilt, you put a little more of your portfolio into stocks that have done well in the recent past.
I don’t know what MTUM’s criteria are exactly, but it may just look at the last three months, so returns over the last 10 years don’t necessarily affect the algorithm.
In short, MTUM gives each stock in its universe, U.S. Large Caps to keep it simple, a score or rank based on each stocks 6 and 12 month momentum. Then, those ranks are further adjusted by the weekly volatility of each stock ( i.e. lower volatility is a positive, higher volatility is a negative… If you want to start down the rabbit hole for this volatility adjustment: https://alphaarchitect.com/2015/11/23/frog-in-the-pan-identifying-the-highest-quality-momentum-stocks/ ). Once the risk-adjusted momentum ranks are set, they choose the highest ranked stocks and adjust by market-cap.
It is actually more complex then that (shocker!) and the entire process can be read about here: https://www.msci.com/eqb/methodology/meth_docs/MSCI_Momentum_Indices_Methodology.pdf
It is a lot and does not exactly help those new to factors get a sense that it is a simple investing style. I wish it were simpler.
One of the big knocks on MTUM is that it re-balances twice a year which flies in the face of normal momentum testing, which re-balances monthly (12x per year). To help offset the loss from more infrequent re-balance periods, MTUM tends to be more concentrated (AQR’s momentum fund has 441 positions as of 9/30/17 while MTUM has 123 as of 11/23/17). There is a book called “Quantitiative Momentum” that goes into the subject of concentration v. re-balancing frequency (Down and down we go into the momentum rabbit hole).
So, as you can see, the factor world is messy, can be complex, and has its own issues of standard stock selection rules. There is no free-lunch there and the above few paragraphs are one of many reasons why a lot of people tend to stay away from factors and stick to more simple and low-cost approaches.
Just need to find your path.
I’m not sure of the role of factors going forward. I had a very careful “diversified” portfolio with about a dozen factors going into 2007-2009 but everything seemed to go down together. The only thing that didn’t go down for me were my bonds. I now diversify outside of stocks rather than within stocks.
There likely is some benefit to having multiple types of stocks but it adds complexity and cost that may not be worth it. Furthermore, as Bill Bernstein has pointed out, just because something did well in the past doesn’t mean it will continue to outperform in the future.
For those who want to learn more about factors, this is a great source. If you would rather just buy all stocks and leave them alone, you will be fine without that extra time, cost, and hassle.
Read this book a while back.
I get that historically momentum has been the most powerful factor and it supposedly is negatively correlated with the value premium which should be great to combine value and momentum BUT….
Philosophically I just can’t buy into momentum. This may be in part because I haven’t dug into the methodology of these funds but is also in part because it seems to do the opposite of what makes me intuitively believe in value stocks, though admittedly for a different duration.
I came to the conclusion that I would not have the conviction to stick with and rebalance into a momentum fund over a decade plus of poor performance.
But have compromised to but MTUM on my watch list as well as look out for other emerging large, low cost momentum ETFs.
I firmly believe many of these factors will end up being statistical anomalies, either noise or temporary. I want to see more momentum data and don’t mind being late to the party.
KISS-keep your portfolios simple
There are NO MAGIC BULLETS
Also see Swedroe’s recent article in ETF.com, “Managing Risk With Factors”.
He added the following note:
“Kevin Grogan and I are working on an update to “Reducing the Risk of Black Swans.” It will include not only more recent data and evidence from the latest research, but also a discussion of certain alternative investments with unique sources of risk and return, and how they broaden the opportunity set and allow for building even more efficient portfolios. We hope to have it published early next year.”
This book is an easier read than “Your Complete Guide…” and I’m looking forward to the revision.
Two thoughts here:
1) After reading so many convincing arguments that indexed mutual funds that contain most if not all of the stock and bond markets is the superior investing strategy, isn’t tilting in general, and towards momentum specifically, a slide backwards into the active management strategies that have been shown to be no better than monkeys throwing darts to pick investments?
2) If a momentum fund is selling and buying multiple times per year as part of the strategy to grab the “hot hands,” is there not a very good chance that any of the anticipated additional return will be wiped out by increased trading costs and short-term capital gains?
(1) Not really. Tilting (overweighting) a subset of stocks (eg. value stocks) that have characteristics that research has shown outperform the broad market (the value premium) is not the same thing as an active manager buying stocks, that in his/her opinion, will outperform the market. The latter is the monkey throwing the darts. The former is not. (2) To some extent, yes. These funds should be held in a tax protected account to avoid taxes, and the trading costs will have some impact on returns.
You mean outperformed and may outperform in the future.
1. It takes some faith to believe in it given the reliance on a limited set of retrospective data. But it’s also the only data we have.
2. Sure. Costs matter. One approach is to simply control what you can control, diversify broadly, and accept market returns. A believer in factor investing would say you’re only using one factor-beta instead of getting “true diversification.” So the question is “Is more diversification more securities evenly weighted by capitalization or is more diversification tilting toward more factors. Is momentum just as good as beta? etc.
Thanks for an excellent review. Another book for us investing nerds, about the same approach of diversifying across the sources of return (factors) instead of traditional asset classes, is Larry Swedroe’s “Reducing the risk of Black Swans – using the science of investing to capture returns with less volatility”. Maybe worth a review, also?
What do you think of using Dual Momentum (Gary Antonucci) as a way of possibly capturing the the momentum premium?
https://www.whitecoatinvestor.com/dual-momentum-investing-a-review/
USAA just introduced a set of ETFs which combine factors:
USAA MSCI USA Value Momentum Blend Index ETF (ULVM), net expense ratio of 0.20%
USAA MSCI USA Small Cap Value Momentum Blend Index ETF (USVM), net ER 0.25%
USAA MSCI International Value Momentum Blend Index ETF (UIVM), net ER 0.35%
USAA MSCI Emerging Markets Value Momentum Blend Index ETF (UEVM), net ER 0.45%
That’s right. I remember seeing that and applauding it. Bought time USAA did something competitive on the investing side.
Interesting, Vanguard introducing 5 “active” factor ETFs next year, including a momentum ETF with ERs of 0.13%. Worth keeping an eye on. Also maybe a multi factor ETF at 0.18% that would combine momentum, value, quality.
I’m actually quite shocked to read this. I was actually first introduced to the concept of momentum on the comments section of one of your posts a few years back. There was a TON of debate and one person really got hammered by both WCI and many of the other comments. I try to remain open and learned more about it. Ironically over the past 1-3 years Momentum would be one of the only things keeping people in the market. The valuation aspect is outrageous yet we have kept spinning higher. Glad to hear that WCI is opening his mind too! At some point, Momentum will be the wrong short term factor and Value will be the better play…..the billion dollar question that nobody can answer is when! From what I have learned though, Momentum does quite well long term so I have factored that in to my porfolio to a limited degree.
A recent freakonomics podcast talked about how many landmark studies done in the past have not been able to be replicated due to various biases and flaws in design. They talked about how this was especially true in economics and with retrospective data. Have you come across any articles/studies to suggest this was the case with some of the core factors like value and size?
Not yet, but the bottom line is there simply isn’t much data, basically 3 non-overlapping 30 year periods.
This momentum factor sure is interesting and the data you’ve summarized is compelling. But I’ve been burned by backtesting before, and my IPS states that I shall not invest in any fund that did not exist prior to the 2008 crash. Which none of these new factor funds did. So I’m on the sidelines for the time being.
That’s an interesting IPS line. Reminds me of one I had that I would invest in international small or small value if I ever found a good fund for it available to me. So when Vanguard opened up theirs I was one of the first into it.
I’m curious what your decision was and how you arrived at it regarding whether or not to try out momentum?
I didn’t add it. Don’t recall the reasoning. Maybe it was the fact that hundreds of factors seem to be coming out every year.
To my ears, there has been a lot of “Factor Noise” recently on bogleheads and Larry Swedroe etc. It’s making me wonder if I should be making adjustments to my portfolio and placing some degree of “Factor tilt”, especially now that Vanguard (where I have most of my investments) has funds geared for it.
1) I wanted to know your thoughts on these vanguard funds, namely VFMF/VFMFX.
2) You have decided to incorporate some factor tilt via small value, why wouldn’t a multifactor fund make more sense?
thanks