Swedroe: Examining Factor Persistence

In our book, “Your Complete Guide to Factor-Based Investing,” Andrew Berkin and I provide five criteria a factor should meet before you consider investing in it. Specifically, there should be evidence of its:

• persistence (does the factor historically deliver reasonably reliable returns?)
• pervasiveness (does it, on average, deliver these returns in a variety of locales and asset classes if such tests apply?)
• robustness (it shouldn’t be dependent on one very specific formulation but fail to work if other, related versions are tested)
• intuitiveness (does it make sense to us, or are we just going by historical performance?)
• investability

Aside from investability, all of these criteria eventually come down to some aspect of whether we believe the historical results are real and not just a result of data mining. Investability is the one that differs, implicitly asking an all-important question: Even if we believe the factor is real, can an investor make money from it after costs?

In our book, we reviewed academic evidence demonstrating that both the value and profitability factors were pervasive around the globe. Another test of pervasiveness for equity factors is whether they have provided premiums across sectors/industries.

With this latter metric in mind, Dimensional Fund Advisors decided to test if the value and profitability factors were indeed persistent across sectors, not only in the U.S., but in non-U.S. developed and emerging markets.

Sector & International Study

In their September 2018 article, “Value and Profitability Premiums Across Sectors,” Dimensional’s research team defined sectors as “collapsing GICS and Bloomberg sectors into consumers, manufacturing, technologies, financials, and healthcare.”

The U.S. data covers the period 1975 through 2017; non-U.S. developed markets data covers the period 1990 through 2017; and emerging markets data covers the period 1994 through 2017. Thus, we have three markets and five sectors, providing 15 tests for the value factor and 15 tests for the profitability factor, a total of 30 tests.

In the 15 tests of the value premium, there was a value premium in all but one case (growth stocks outperformed value stocks in the technology sector in emerging markets). Similarly, in the 15 tests of the profitability premium, there was a profitability premium in all but one case (less profitable U.S. health care stocks outperformed more profitable ones).

Dimensional’s researchers noted that “while focusing on individual premiums can help investors increase the expected return of a strategy, integrating multiple premiums can not only provide investors with more information about differences in expected returns but can also improve the reliability of investment outcomes.”

With that in mind, they examined the effect of focusing on both the value and profitability premiums simultaneously in each sector. To do so, they formed in each sector a group of stocks with low relative price and high profitability. Similarly, they formed a group of stocks with high relative price and low profitability. Once again, they found that premiums existed in 14 of the 15 cases (the one exception was technology stocks in emerging markets).

Summary

In our aforementioned book, we provided the evidence on the pervasiveness of the size and profitability premiums across the globe. Dimensional’s study offers further compelling empirical evidence in support of the value and profitability premiums at the sector level. Such confirmation should give us greater confidence that the historical premiums were not the result of data mining exercises, and thus are likely to persist.

For those interested in learning more about each of these factors (as well as the market beta, size, momentum, quality, low beta/low volatility, carry and term and debt factors), I recommend our book.

(Full disclosure: My firm, Buckingham Strategic Wealth, recommends Dimensional funds in constructing client portfolios.)

Larry Swedroe is the director of research for The BAM Alliance, a community of more than 140 independent registered investment advisors throughout the country.