Swedroe: Long Term Factors

June 25, 2018

Factor-based investing seeks to capture the long-term premiums highlighted by academic researchers. Factors are the security-related traits/characteristics that give rise to common patterns of return across broad sets of securities.

To identify factors, researchers typically construct long/short portfolios that are long the preferred exposure and short the unwanted exposure. Most mutual funds employing factor-based strategies are long only. Funds that are long/short typically are referred to as style premium funds (i.e., AQR’s Style Premia Alternative Fund (QSPRX)). They offer a “pure play” on the premium by eliminating (or by minimizing) exposure to market beta that comes with long-only strategies. Thus, they provide additional diversification benefits. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends AQR funds in constructing client portfolios.)

Unfortunately, the financial media and some practitioners refer to factor-based investing as “smart-beta” investing. When asked about the term “smart beta,” Nobel Prize-winner William Sharpe’s response was that it made him sick. While much, if not the vast majority, of what Wall Street will call smart beta makes me sick as well, one can make the mistake of throwing out the proverbial baby with the bathwater. That’s what I believe Bill Sharpe and many others may be doing.

I’ve explained before why I think most of what is called smart beta is really nothing more than a marketing gimmick—the result of loading on factors (such as size, value, momentum and profitability/quality) other than market beta. Most smart beta products are not delivering alpha (which is what is often implied by the term “smart”), just beta on other factors.

However, as I’ve also pointed out, pure indexing strategies possess certain weaknesses that can be minimized, if not eliminated. Creating fund construction and implementation rules that do so could be described as smart beta.

Long-Term View On Factors

Elroy Dimson, Paul Marsh and Mike Staunton contribute to the literature with their study, “Factor-Based Investing: The Long-Term Evidence,” which was published in a special 2017 issue of The Journal of Portfolio Management. Their objective was to look back in time across more than 100 years of data and 23 countries to determine if there are reasons to believe cross-sectional patterns in returns will persist, or whether they are just anomalies that tend to disappear after publication.

The authors’ study examined the size, value, income (or yield), momentum and volatility factors. They noted that these are far from new phenomena; Dimson described all of them three decades ago in his 1988 book, “Stock Market Anomalies.” In other words, we now have decades of out-of-sample evidence, not only in the U.S., but also from many other countries.

Dimson, Marsh and Staunton begin by noting: “The returns to factor exposures vary across risk factors, they can be quite divergent, they differ between countries, and they fluctuate over time. These factors matter a great deal because small companies will continue to perform differently from large stocks—even if they fail on average to outperform—and similarly, value stocks, high yielders, and past winners will continue to show different performance characteristics from growth stocks, low yielders, and past losers, regardless of whether they generate a premium.”

I’ll review their findings, as well as add a few of my own thoughts and observations through other data.

Size Factor

Viewed in an international context, smaller companies perform very differently (that is, the size effect is a unique/independent factor) from larger companies, and have provided, the authors found, an annual premium of 3.8%. We can also see the size effect in terms of absolute returns to long-only portfolios.

From 1926 through 2016, a dollar invested in larger U.S. companies grew in value to $4,690, while a similar investment in U.S. small-cap stocks gave a terminal value of $33,879, more than seven times greater. U.S. micro-cap stocks did best of all, with an ending value of $53,263. The returns on U.S. large-cap stocks were an annualized 9.7%, while small-cap and micro-cap stocks achieved 12.1% and 12.7%, respectively.

Dimson, Marsh and Staunton noted the size premium has been larger since the turn of the century, a period of relatively poor performance for equities. From 2000 through 2016, the size premium was positive in every country except Norway, and averaged 5.6% per year.

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