As the chief research officer for Buckingham Strategic Wealth and the BAM Alliance, I receive many questions from advisors and investors regarding concerns about factor-based investment strategies. A brief background on factor-based investing is helpful before discussing those concerns.
William Sharpe, Jack Treynor, John Lintner and Jan Mossin are typically given most of the credit for introducing the first formal asset pricing model—the capital asset pricing model (CAPM). It was important because it provided the first precise definition of risk and how it drives expected returns.
Fama & French Take It Further
The CAPM looks at returns through a “one actor” lens, meaning the risk and return of a portfolio is determined only by its exposure to market beta. In the 1993 publication of the study “Common Risk Factors in the Returns on Stocks and Bonds,” Eugene Fama and Kenneth French proposed a new asset pricing model, which became known as the “Fama-French three-factor model.” This model proposes that, in addition to the market beta factor, exposure to the factors of size and value further explain the cross section of expected stock returns.
The authors demonstrated that we live not in a one-factor world but in a three-factor world. They showed how the risk and expected return of a portfolio is explained by not only its exposure to market beta but by its exposure to the size (small stocks) and price (stocks with low prices relative to book value, or value stocks) factors.
Fama and French hypothesized that, while small-cap and value stocks have higher market betas (more equity-type risk), they also contain additional unique risks (they are not free lunches) unrelated to market beta. The Fama-French three-factor model improved the explanatory power from about two-thirds of the differences in returns between diversified portfolios to more than 90%.
The Fama-French model became the workhorse model for financial economists. The fund family Dimensional Fund Advisors (Fama and French led their research efforts) led the way in introducing factor-based funds based on the Fama-French research. (Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)
Today, while hundreds of factors have been identified in the literature, only a few are generally accepted as adding incremental explanatory power. And while there is some competition as to which is the best model, the most accepted four- and five-factor models include some combination of market beta, size, value, momentum, profitability and investment.
With that background, we’ll now examine three concerns that are often raised about factor-based investing. The first is that factor-based investing is complex.
Factors Introduce Complexity
An objection often raised is that factor-based investing introduces complexity. The increase in complexity refers to the increase in the number of funds needed to build a portfolio. Investors in total stock market funds need only two equity funds. For example, they could invest in the Vanguard Total Stock Market ETF (VTI) and the Vanguard Total International Stock ETF (VXUS).
However, investors can also build global factor-based portfolios with just two funds. For example, the “Larry Portfolio,” highly tilted to small and value stocks, requires only two funds. Personally, I use the Bridgeway Omni Small-Cap Value Fund (BOSVX, or BOTSX for taxable accounts) for U.S. exposure, and the DFA World ex-U.S. Targeted Value Fund (DWUSX) for international exposure.
Of course, there are many other choices that don’t require the use of more than a few funds. As just one example, Goldman Sachs recently introduced a suite of what they call “active beta ETFs” (Goldman Sachs ActiveBeta), which provide exposure to four factors: value, momentum, quality and low volatility.
For example, you could build a global portfolio using these three ActiveBeta funds: the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC), the Goldman Sachs ActiveBeta International Equity ETF (GSIE) and the Goldman Sachs ActiveBeta Emerging Markets Equity ETF (GEM).
If you wanted more small exposure, you could add the Goldman Sachs ActiveBeta U.S. Small Cap Equity ETF (GSSC). Or you could use two of Dimensional Fund Advisors’ (DFA) funds: either its U.S. Core Equity 1 (DFEOX) or its U.S. Core Equity 2 (DFQTX), and its World ex-U.S. Core Equity Portfolio (DFWIX).