To demonstrate this point, we’ll examine the live returns of the factor-based funds with the longest track record, those of Dimensional, and compare their returns with those of the marketlike portfolios of the premier provider of index-based strategies, Vanguard.
We’ll look at data for the longest period that both the factor-based fund of Dimensional and the total market fund of Vanguard have been available. Using live funds allows us to account for fund expenses and trading costs. Data is from Portfolio Visualizer.
In each of the nine cases, the factor-based fund run by Dimensional outperformed the Vanguard total market fund, with the outperformance ranging from 0.6 percentage point to as much as 4.8 percentage points.
Despite the higher fund expenses, both in terms of expense ratios and trading costs (due to higher turnover and trading in less liquid small stocks), the nine Dimensional funds produced an average outperformance of 2.6 percentage points. Even if factor-based investing were to add a small amount of complexity, it’s safe to conclude most investors would find the complexity more than compensated for by the added return as well as the demonstrated diversification benefits.
One other point to consider is that, by increasing exposures to factors that have expected premiums, investors can lower their exposure to market beta because the equities they hold have higher expected returns than the market. That allows them to hold more safe bonds. And by purchasing individual Treasuries directly or CDs, investors can eliminate the costs of a fund manager.
The savings reduce the impact of the higher costs of factor-based funds. In other words, you have to consider the total portfolio’s implementation costs and not look at the expense ratios of the funds used in isolation.
As you have seen, well-designed factor-based strategies, which focus on the factors that have provided evidence of persistence, pervasiveness, robustness to various definitions and survive transactions costs, while also having intuitive explanations for why their premiums should persist, have historically provided higher returns than market-based strategies. In addition, they have provided significant diversification benefits, performing well over the three long periods when market beta provided no risk premium at all.
In addition, factor-based strategies do not require a great increase in complexity, as we now have many multifactor funds that can be used to develop globally diversified portfolios. And while they tend to be somewhat more expensive, they are not necessarily dramatically higher than those of marketlike portfolios.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.