One more point to make is that not all “complexity” is bad. There’s a quote, often attributed to Einstein (anything you attribute to him gives it credibility): “Everything should be made as simple as possible, but not simpler.” If adding one or two funds to the two total market funds adds value by diversifying sources of risk and return, then the complexity is good, not bad.
There really isn’t much difference in complexity between a portfolio of two equity funds and one with three or four. The bottom line is that building a portfolio of factor-based funds doesn’t have to be any more complex than building a portfolio of total market funds.
We now turn to the second concern often raised: A factor can provide negative returns for a long time.
Factors Can Lag For Long Periods
It is true that all factors are likely to go through long periods of underperformance. In the most recent example, the value premium was an annual average of -1.9% a year from 2009-2018, and it was 0% outside the U.S. (Data is from Ken French’s website). However, what advocates of total market funds may fail to recognize is that the same is true for the one factor in which they have concentrated all their equity risks—market beta.
For example, we have had three periods of at least 13 years over which the S&P 500 provided no risk premium relative to riskless one-month Treasury bills. The table below shows the annualized premiums for the U.S. market beta premium as well as the annualized premiums for size and value (Fama-French research factors) over the same period. (Data is from Ken French’s website.)
The table provides some important takeaways. First, the market beta factor goes through long periods of underperformance. Second, the three periods total 44 years, or almost half the period for which we have data on U.S. stocks. Third, in each of those periods, while market beta (the U.S. stock market) did not provide any risk premium, the size and value premiums were large—the size premium averaged 4.9% and the value premium averaged 5.0%. Clearly, diversifying across factors provided significant benefits.
The problem for investors is that there are no gurus who can predict which factor will provide premiums in the future. Thus, the prudent strategy, when you don’t have a clear crystal ball, is to diversify the sources of risk and return in your portfolio.
Wise investors know that diversification means some part of your portfolio is almost always going to be underperforming. If there is never any pain, there will not be a premium. In addition, they know that diversification from the market portfolio means accepting the risk of tracking error and having to live with that pain for long periods. That’s the price you have to be willing to pay to gain the benefits of diversification (as evidenced in the table above).
We now turn to the third concern: Factor-based strategies are more expensive.
Factor-Based Strategies Pricier
While the statement is true in a relative sense, factor-based strategies do not have to come with high expense ratios. For example, the expense ratios of the aforementioned DFA core strategies range from 0.19% to 0.23% for the domestic funds (DFEOX and DFQTX, respectively), and 0.39% for their international core fund (DFWIX).
Vanguard’s U.S. Multifactor Fund Admiral Shares (VFMFX) has an expense ratio of just 0.18%, while the Goldman Sachs ActiveBeta U.S. Large Cap Equity ETF (GSLC) costs just 0.09% (its international fund costs 0.25% and its emerging markets fund costs 0.45%). And today there are many low-cost, factor-based ETFs from which individuals can choose. Factor-based investing needn’t be expensive.
That said, expense ratios should not be the only consideration when choosing a fund, except if choosing between two index funds based on the same index.