Importance of Factors by Chris Patterson
The relative importance of factors is a big subject. As Wes Gray points out in his excellent blog post “Factor Investing is More Art and Less Science,” the list of most important factors is a moving target.
Larry Swedroe makes a case for 8 factors (two for fixed income and 5 for equities) in his book “Your Complete Guide to Factor-Based Investing.” The equity factors and premiums he lists are:
* Market Beta — 8.3% (over risk-free)
* Size — 3.3%
* Value — 4.8%
* Momentum — 9.6%
* Profitability — 3.1%
He also makes the point that as portfolios tap more factors, they become more diversified and produce more consistent results. One of the concluding recommendations is that a single fund with exposure to multiple factors (especially market, momentum, and value) should be preferred because it avoids the need to rebalance between funds with exposure to fewer factors. The problem I have with that conclusion is availability and efficiency.
Last Fall, I did an analysis of available funds using Portfolio Visualizer and found that though there are many available 3-factor funds with exposure to the market, size and value factors (e.g. a small cap value fund), there are very few funds with exposure to 4 or more factors or even efficient exposure to the momentum factor. Here's an area chart from that analysis.
You can also see that there are many more small, small-value, and value funds with high factor-predicted returns compared to momentum funds.
You can see the difference in the efficiency of small cap value funds vs. momentum funds in the two charts below.
So, which factors do I think are most important? For equities, I prioritize efficient access to the market, value, and size factors in that order, then look for funds that also give exposure to profitability and momentum where possible. In a sense, profitability/quality, momentum, and even low-volatility become tie-breakers. I've written a couple of articles on how we do this in the selection of our Best-in-Class ETFs.