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.
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.
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,
- Kizer uses size not profitability in his study of factor-based diversification. [↩]