New Swedroe Book: ‘Your Complete Guide To Factor Investing’

Larry Swedroe is a principal and the director of research for Buckingham, an independent member of the BAM Alliance, and a regular contributor to ETF.com. He was among the first authors to publish a book explaining passive investing in layman's terms—"The Only Guide to a Winning Investment Strategy You'll Ever Need," and his latest book looks into factor investing, "Your Complete Guide To Factor Investing.” He will be giving a talk at Inside ETFs, “Thinking Differently About Diversification” in Florida on Jan. 24, 2017. We sat down with him to discuss factor investing, diversification and more.

ETF.com: Let’s talk about your new book, "Your Complete Guide To Factor Investing.” Why did you decide to write a book on smart beta?
Larry Swedroe: I would say two things. One, factor-based investing has now become the new-new thing, especially after the crisis of 2008. And secondarily, there are over 600 factors that have been identified and there was no book out that helped the individual investor make a good decision on which of the 600 they should focus on.

My colleague Andrew Berkin and I put together a list of criteria we think are helpful for people when they think about any strategy in the future. It should be persistent across economic regimes, meaning long periods of time, so you know it wasn't just a lucky, good economic tie-in period for that factor.

The factor or strategy should be pervasive wherever you look; meaning across industries, sectors, countries, regions and even asset classes. It should be robust to various definitions. For instance, I would be less confident of the value factor if it only worked for price-to-book. But it works for price-to-cash flow and earnings. And momentum works for various holding periods and formation periods.

It should be intuitive. And lastly, it has to be implementable. A factor has to survive transaction costs.

ETF.com: You bring up 600 factors. That’s staggering.

Swedroe: Most of the 600 either don't pass the tests that I just laid out, or using the technical term, they can be subsumed by other factors; meaning, their returns are explained by other well-known factors that we already have. You don't need all the 600.

The good news is that there are really only a relatively small number of factors. For equities, we have market beta, size, value, profitability and quality. You also can add carry, which works across asset classes. And for bonds, the only one we think meets our criteria is term premium. That’s eight out of the 600.

ETF.com: What’s one of the biggest mistakes advisors and/or investors make when it comes to factor investing, especially if they're new at it?
Swedroe: The No. 1 mistake would be failing to have a strong belief system built from meeting all of those criteria I mentioned. You’re much more likely to stay the course through the inevitable long periods of underperformance every factor goes through.

Failing to understand that is a real problem, because what I've learned in my 20 years of experience as an advisor is that most investors, including institutional investors, think three years is a long time; five years is a really long time; and 10 years an eternity.

Financial economists know that when it comes to risky assets or factors, 10 years is nothing more than noise. That's the problem investors have: They fail to understand that, and abandon the factors.

ETF.com: Can investors do this by themselves, without an advisor?

Swedroe: It's certainly possible for an individual to do it, but—and I may be overstating it—probably a maximum 5% of individuals can really do it on their own. Warren Buffett has written for years what his strategy is. But very few people get Buffett-like results, because it isn't easy. Temperament matters more than intellect.

Advisors are likely to avoid behavioral errors because they're unemotional with other people's money. With your own money, you're much more likely to make mistakes simply because we're human beings and we are subject to emotions.

I think there’s a very small percentage of people who can really do it on their own. The vast majority would be better served by working with an advisor who will help them lay out the right plan.

Temperament matters most, but intellect is also crucial. You have to have a high level of mathematical understanding to figure out things like expected returns and how to run Monte Carlo simulations to figure out the right asset allocations to give you the best chance of achieving your goal. You need intellect in specific areas, and you need the temperament to stay the course.

ETF.com: One of your chapters is titled "The Truth About Smart Beta." What is the truth?

Swedroe: I don't want to say that there's no such thing as smart beta, but I believe the vast majority of things that are called smart beta are pure marketing gimmicks.

Let's see if I can separate what is smart beta from what is called smart beta.

First, let's define beta as a loading on a factor. And if it's just loading, there's nothing smart about it. It's just how much beta you have on the factor. If a fund construction rule gives you more loading on a factor so you own the bottom 30% of stocks by price/earnings ratio, then another fund that owns 20%, that's not smart beta; that's just getting more exposure to this factor. There's nothing smart about that construction. It's just getting more exposure.

Having said that, there are many ways a well-constructed, well-run mutual fund or ETF can add value, because there are some things that index funds do that are negative. All index funds, except the total market funds, are basically dumb indexes.

For example, take the Russell 2000 [index of the bottom 2,000 stocks in the Russell 3000 Index]. A stock that's ranked 1001 is in the Russell 2000, and a stock that's ranked 999 isn't. Every year the index reconstitutes. Imagine that a stock ranked 999 and 1001 swapped places.

Now, a Russell 2000 fund has to trade both, buying and selling, when both stocks are virtually identical from a risk and expected return perspective. They have the same loading on the factors that explain return.

So why do you want to trade? Especially when you know that the active managers know when you have to trade, and will front-run you and exploit you. That's just dumb. That's what index funds do. Their sole goal is to be a replicator and avoid tracking error. To me, that's dumb. I'm willing to accept what should be random tracking error if I can gain a higher expected return.

ETF.com: Let's talk a little bit about multifactor ETFs. There’s a wider understanding among advisors that factors have periods of underperformance. That seems to be one of the selling points of a multifactor fund that rotates factors.

Swedroe: It really depends on how you construct it. You want to add factors that not only have premiums and meet the tests I laid out, you want to add a factor portfolio that also has low-to-negative correlation to the other assets in your portfolio, because that'll add a diversification benefit.

Two of the classic factors having negative correlation are momentum and value. You would expect a negative correlation, because how do you get to be a value stock? You have relatively poor performance and then it drops, and now you've got low prices to some metric, whether it's price-to-book earnings or cash flow, and the value fund starts buying it, but negative momentum would be shorting it.

Now, imagine you've got two funds, because you want exposure to momentum and value, and the stock is dropping into value so your value fund is buying it, and you're paying that value fund an expense ratio. It's engaging in trading costs. And the momentum fund at the very same moment is shorting it. Now you've paid that fund an expense ratio and you've incurred the trading costs, and you've had obviously no impact on the portfolio, except the negative impact of trading costs.

It's much better to incorporate funds that screen for multiple factors. You avoid the trading costs. And you avoid two fees. It’s common sense. That's something most investors unfortunately don't think through.

ETF.com: In terms of an everyday investor—not an institution or someone sophisticated—is smart beta worth wading into? Or would investors be better off maintaining their market index positions?

Swedroe: I would only recommend it to people who are serious students and willing to take the time to invest in learning about the factors, reading books that will give them the strong belief system, the understanding of why they might consider things. If you don't have that, as I said, you're almost certainly doomed to fail.

The second thing is research shows that diversification across factors that have premiums and low correlations have historically resulted in significantly more efficient portfolios. Low correlation dampens the volatility of the overall portfolio.

At my firm, we’ve been using these strategies for 20-plus years now. I believe they’ve greatly reduced the risk for our clients so that they suffered much lower losses in 2002 and 2008 than they would have had with more marketlike portfolios.

The reason is that because the equities they held had much higher expected returns, they could own less equity risk overall and own more safe bonds. When the risk to all risk factors shows up, those safe bonds tend to go up in value.

By adding factors that have premiums and low correlation, and adding more fixed income, historically you ended up with more efficient portfolios. Academic literature shows that factor diversification provides more diversification, better benefits for market directionality and volatility than just focusing on the single factor of beta.

Contact Drew Voros at [email protected]