Highlights.

  • It is very unlikely that stock picking will lead to better results over the long term than investing in a single fund holding shares of all of the U.S. companies whose shares are publicly traded.
  • Extensive academic research has identified several “risk factors” that explain why some groups of stocks tend to outperform the stock market as a whole.
  • “Factor Investing” is a style of passive investing that seeks to generate better returns than the stock market generally by capturing these drivers of equity returns.

Long before Bill O’Reilly became famous, I picked up the nickname “The Factor”.  It happened a long time ago during my first semester in law school.  A couple of my classmates were discussing whether they were prepared for the final exam for the course on contracts.  One asked the other if he felt he was prepared for the test.  When he answered yes, a third chimed in – “Ah, but have you accounted for the Willms (which is my last name) Factor”.  The insinuation was that my exam results were going to throw off the grading curve (which, I can assure you, did not prove to be the case).  For some reason “The Factor” nickname stuck, and my law school buddies (and my brothers) still refer to me as “The Factor”.

This week I would like to consider if there are so-called “market factors” that can be relied on to generate alpha – that is, better performance than would be achieved by a single investment in a total stock market fund, such as Vanguard’s Total Stock Market ETF (VTI).

The efficient market hypothesis theorizes that the current price at which a particular company’s stock is trading reflects all relevant publicly available information that affects the price, and therefore the current price at which a stock is trading is the best indicator of the stock’s true value.  If efficient market hypothesis is correct, then it’s unlikely that portfolio managers who rely on trading will consistently generate better returns than a total stock market fund.  

Support for the efficient market hypothesis can be found in the fact that the large majority of portfolio managers who focus on individual security selection or on market timing have been unable to beat portfolios invested in passively managed index funds.  A recent research report from Standard & Poor’s suggests that the odds of an active fund manager beating a comparable index fund over a 15 year period is roughly just 1 in 20.

Originally, the goal of passive investing was to try and match the performance of the equity market (often referred to as “beta”), rather than beat it (“alpha”).  This traditional form of passive investing still has many followers, as evidenced by the fact that almost $100 billion is invested in VTI.  One of the strongest proponents of traditional passive investing is legendary active investor Warren Buffet, who has said “Both large and small investors should stick with low-cost index funds”.

With the efficient market hypothesis as its starting point, additional academic research suggests that an investor whose portfolio is made up of passively managed index funds can generate alpha by investing in index funds that target certain “risk factors”.  The term “risk factor” refers to a common characteristic that is an important “factor” in explaining the amount of return and degree of risk experienced by a group of stocks that share that characteristic.  

A large body of academic research stretching back to the 1970s supports the assertion that over the long term, a significant degree of the outperformance of various groups of stocks can be explained by risk factors.  This research has led to a twist on traditional passive investing, and is referred to (as one might expect) as “Factor Investing”.  The objective of Factor Investing is to enhance an investment portfolio’s diversification, generate above-market returns and manage risk.

There are two main types of factors that have been identified as being drivers of equity returns.  The first group is referred to as “macroeconomic factors”, and refers to economic factors that influence the performance of the entire stock market.  Examples of macroeconomic factors include inflation, interest rates, inflation, and political conditions.

The second group is referred to as “style factors”.  Seven of the most recognized style factors are:

  • The Value Factor.  The theory behind the value factor is that securities priced at a discount to their fundamental value have historically outperformed those priced at a premium.
  • The Growth Factor.  The growth factor is premised on the notion that stock of companies whose earnings are expected to grow or have strong fundamentals, will outperform shares of companies who have lesser prospects.  In other words, the growth factor focuses more on a company’s expected future value, as compared to its current price.
  • The Quality Factor.  The concept underlying the quality factor is financially healthy companies tend to outperform companies with weak balance sheets.
  • The Size Factor.  The somewhat counter-intuitive assertion here is that stocks issued by smaller companies tend to outperform those of larger companies.
  • The Volatility Factor.  The principle supporting the volatility factor is that stocks with more stable prices tend to generate better returns than stocks whose prices are more volatile.  Accordingly, this factor is often referred to as the “minimum volatility” factor.
  • The Liquidity Factor.  The theory underlying this factor is the stocks of the best companies trade less often.
  • The Momentum Factor.  Last, but certainly not least, the momentum factor stands for the proposition that upward moving stocks tend to continue moving in that direction, and vice-versa.

In the upcoming weeks I will be discussing each of the foregoing style factors in greater degree.  But performance factors are not unique to investing.  Factors can also be used to explain the success of movies.  One movie factor is “the chill factor” (scary movies sell tickets).  Another is the humor factor (the funnier the movie, the more money it will make).  Here is a clip from Beetlejuice, a classic film starring Michael Keaton, that combines both of these movie factors.  Enjoy!

Thank you for reading,

The Market Commentator

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