The return premiums are the radioactive elements of passive investing. On the one-hand they’re potent sources of energy for your portfolio. On the other, they’re complex, risky, and must be handled with caution if they’re not to make your hair fall out.
But what if there was a way to combine the various elements in the reactor chamber of your portfolio so that the risks were reduced and the energy retained?
Well, it turns out there is…
By blending the right premiums (also known as risk factors) you can produce a more diversified portfolio that has the potential to outperform the market.
The key is to choose factors that have a long track record of delivering strong returns and that have little or even negative correlations with each other.
This way, when one factor is having a meltdown there’s a good chance that one of the others is keeping the lights on.
Complementary risk factors
Though cold hard stats are hard to come by, certain risk factors have been shown to work across global markets – including the UK.
The strongest factors have been:
- Value – it’s beaten the market by 4.9% per year in the US and 3.6% in the UK.
- Momentum – beaten the market by 9.6% in the US.
- Profitability – beaten the market by 4% in the US.
Note that passive investors can only expect to gain roughly 50% of the premium (i.e. the outperformance) because we don’t do things like shorting equities.
Still, an extra percentage point or so added onto your annual performance is well worth collecting when you consider that equities have historically averaged only a 5% real return per year.
Better yet, value has had a negative correlation with profitability and momentum, while profitability has had a low correlation with momentum.
The learned Professor Novy-Marx – who discovered the profitability premium – spells out the benefits:
“Over time, tilts towards value, momentum and profitability have outperformed the market, and due to the diversification benefits, a combined portfolio of these three has provided much higher reward per unit of risk and a significant reduction in extreme risk or losses.”
How high is the potential reward?
- Novy-Marx has shown that a dollar invested in the US market in July 1973 grew to over $80 by the end of 2011.
- But if you’d invested it in profitable, value companies with momentum then your dollar would have grown to $955 (before expenses).
That’s a 1,093% increase.
Monevator’s factor flirty portfolio
So how much profitability, momentum and value should you add to your portfolio? Ideally, you’d just forecast the expected returns for each factor, grind them through a mean variance optimizer, wave your magic wand and conjure up the perfect portfolio.
In reality, because nobody can predict the future, even the experts just equal weight them.
Mr. Antti Ilmanen of AQR – a US fund house that leads the way in factor investing – says:
“Because we believe that each of the styles offers similar long-term efficacy, a good starting point for a strategic risk allocation is roughly equal risk-weighting the applicable styles in each of the six asset groups we trade. We believe this can capture the maximum amount of diversification and can lead to the most consistent returns long-term.”
The equity portion of a portfolio heavily weighted towards risk factors could look like this:
- 50% total market (beta)
- 10% value
- 10% momentum
- 10% profitability
- 10% emerging markets
- 10% global property
You would use developed world index funds or ETFs to buy the market as well as the risk factors. Adding an emerging market and a global property tracker bolts-on further diversification.
You could reduce your allocation to beta and increase your risk factor holdings further, but know that the further you drift from the market portfolio, the greater the chance you’ll experience tracking error regret whenever a simple market tracker beats all your fancy funds.
That’s the greatest danger you’ll face if you follow a factor-based strategy.
Individual risk factors can trail the market for years, so you’ll need discipline and courage to keep rebalancing back to languishing funds – all in the face of pundits proclaiming ‘value is dead’ when they need to reach for a cheap headline.
Happily, the author Jared Kizer has shown that at least one factor has outperformed 96% of the time, so hopefully there will always be one asset keeping the flame alive.1
And over time, performance volatility will be your friend, as it’s your chance to scoop a bonus as you rebalance back to your strategic asset allocations – in other words, a classic ‘sell high, buy low’ strategy.
You can always add the small cap and low volatility factors, too, but remember you’ll need to find space for them from the equity part of your portfolio. (Don’t steal from your allocation to bonds, for example!)
Remember that your equities-bond split is the most critical asset allocation decision you’ll make – the one that makes the biggest difference to your ride.
Multi-factor
Many experts believe that a blend of factors is better than a collection of single malts. In the US, you can buy a single multi-factor fund that adds a profitability and momentum screen to a small value strategy.
In other words, you can buy a fund of small, cheap, profitable winners.
Nothing like that yet exists in the UK for DIY investors, although Lyxor’s Quality Income ETF has taken an early stab.
Once we catch up with the US, adopting a risk factor strategy will be as simple as buying a low cost total market fund, diversifying with a multi-factor fund, and then diluting your risk with a bond fund.
But if you can’t wait to get started then you can construct a diversified risk-factor portfolio as I’ve just described, using individual ETFs in the iShares or db X-tracker factor ranges.
Take it steady,
The Accumulator
- Kizer uses size not profitability in his study of factor-based diversification. [↩]
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For my passive investments (mostly my son’s ISA) I just do the boring equally split thing between global stocks and bonds. I think the market’s pretty efficient and if everyone can just jump into mechanical ETFs loading up on value/momentum and so on then the efficiencies will reduce returns for those specific mechanical rules.
Also it will probably take 10 or 20 years before you know if your portfolio is really doing any better than a vanilla spread, so with passive investments I’d rather just do the most boring thing possible and forget about it.
Of course with active investing it’s a completely different story…
Keep it simple & enjoy life. You only have one.
@accumulator – it would be fascinating to know if/how you have incorporated all this ‘smart-beta’ into your portfolio. I laboured under the commont delusion for a while that you were running something similar to the ‘passive-portfolio’ until that was cleared up. The reality must be far more sopisticated and exotic judging by you recent series of articles.
Maybe you could tell us, or if its private just drop a few hints to pique our interest..
@UK Value Investor “Also it will probably take 10 or 20 years before you know if your portfolio is really doing any better than a vanilla spread” I totally agree with You but factoring works because for a long time it underperfoms the “vanilla spread” market. And ordinary people are not patient and unable to wait for years.
@The Accumulator I’d like to echo The Rhino’s request, if it isn’t too personal. I was quite happily sat here with my index tracking funds for the developed world and your recent articles are tempting yet seem far more like active investing than I’d like. (I’m pretty sure I’ve got the temperament to sit and hold my tracker funds for years to come through just about any market conditions; if I start chasing smart beta or whatever I’m not so sure I’m not going to lose heart in the middle of the next bear market, change horses midstream and get wet…)
@The Accumulator “I’d like to echo The Rhino’s request” Me too.
Hi all, sorry it’s taken me so long to reply. Work has been mad.
I currently invest in small cap and value and have done from a very early stage.
The main passive investing champions – Bernstein, Ferri, Swedroe, Hale, Burns – all made the case years ago for small cap and value, with only Bogle in the opposing camp. Most of them have commented positively about momentum and profitability too in the last couple of years.
They all sound notes of caution though: results are not guaranteed, you have to be disciplined and stick with it even when your monkey brain is screaming “Noooo!” because a factor has taken a kicking for 5 years. Unquestionably this type of investing – often called style (or factor) investing – adds complexity and risk to your portfolio.
Smart Beta is simply a marketing term designed to popularise this style of investing.
And Smart Beta has succeeded in increasing our options when it comes to style / factor investing. It wasn’t possible to invest in an ETF in this country that gave you access to quality or momentum, until this year.
My personal position is that I won’t take positions in individual momentum or quality products at this time. I’m holding out for a multi-factor fund that incorporates these factors along with small value. That might take years to arrive but these products already exist in the US.
What interests me most is, regardless of the lure of outperformance, combining those factors potentially leads to greater diversification and thus less volatility in a portfolio.
For what it’s worth, I’m not a fan of low volatility: http://monevator.com/low-volatility-problems/
I don’t like the available quality products: http://monevator.com/how-to-invest-in-the-profitability-or-quality-factor/
And I’ve yet to properly drill into the new value and momentum ETFs released by iShares and db X-Trackers. I will post on those in the New Year though.
The bottom line is that I’m convinced by the research that underlies factor investing, I’m not necessarily convinced by the first wave of products that purport to realise that research, and I wouldn’t blame anyone for staying out of it.
There’s a lot to be said for keeping things simple.
Hi TA. There’s at last a multifactor ETF from iShares… ‘IFSW’. Any thoughts on this?
Thanks for letting me know Algernond. I’ve just downloaded a load of papers on the index methodology so that’s some light bedtime reading for me. It certainly is combining the factors I’m most interested in: value, size, momentum and quality (a variant on profitability). I’ll need to do some research but in the meantime here’s some thoughts from the Bogleheads:
https://www.bogleheads.org/forum/viewtopic.php?t=162821
That Bogleheads stuff is all a bit hardcore for me…. guess I better understand it all though to try to judge whether 0.5% TER is worth it.
Hi TA – I just got this response from HL when asking them to make it available on their platform:
‘In order for a stock to be eligible to trade on the HL Vantage platform, the stock must trade and settle through the Crest settlement system. We take each stock on a case by case basis to determine Crestability. Unfortunately IShares FactorSelect MSCI World UCITS ETF (IFSW) does not currently settle in Crest and we are therefore unable to trade them. ‘
@TheAccumulator – Very interesting post. I love the idea of buying a multi-factor fund, or at least one which included value and size.
Two years on, do you know if there are now any products available here in the UK that provide this?
Hi Joe, yes there is: http://monevator.com/building-a-multi-factor-portfolio-with-ishares-factorselect-msci-world-etf/
Sweet, thanks. Looks like a really nice ‘treat’ to add to a passive portfolio increasing diversification.
I see in your linked post you say you’ll check out the Amundi ETF Global Equity Multi Smart Allocation Scientific Beta. I’ve searched the site but can’t see a specific post comparing the two – apart from the Amundi ETF is listed in your hugely useful ‘cheap trackers’ round up.
Do you have any thoughts on whether the addition of ‘quality’ in the IFSW is worth the extra 0.1% OCF or do you think the cheaper Amundi offering is better? (I understand this isn’t financial advice). Thanks.
Think of quality as a variant along the lines of profitability. Evidence suggests that size, value, momentum, quality / profitability have historically complemented each other very well, so I’m prepared to pay the smidge extra in the hope I benefit from those relationships in the future.