Swedroe: Using Factors To Lower Risk

December 23, 2015

Many investors today are confronting what could be considered a “perfect storm” that is creating strong head winds against the pursuit of higher expected returns. So far, we have discussed the main factors currently working against investors, as well as some steps they might consider taking to help combat this problem.

We will now examine why increasing your exposure to certain investment factors not only can provide higher expected returns and a diversification benefit, but also can help mitigate risk.

They’re Called Risk Assets For A Reason

Before we continue, however, there’s an important warning to heed. Because none of us has a clear crystal ball when it comes to predicting the future, the diversification of risks should be the guiding principle in many investment decisions. Thus, all decisions should be made “in moderation.”

For example, while we mentioned a good starting point for holding international stocks is 50% of your equity allocation, I would be very cautious about having that allocation exceed 60%. And with emerging markets making up about 12.5% of global equity markets, I’d be very cautious about allocating more than, say, 25% of your equity allocation to that asset class.

You also should be very sure that you will be able to “stay the course” during the inevitable long periods when all risky assets will perform poorly. No asset class that is risky is immune.

A good example of the risk of tracking-error regret is the period 2003 through 2014. From 2003 through 2007, the S&P 500 Index returned 12.8%, the MSCI EAFE Index was able to return 22.1% and the MSCI Emerging Markets Index returned 37.5%.

Then, from 2008 through 2014, while the S&P 500 Index returned 7.3%, the MSCI EAFE Index returned 0.0% and the MSCI Emerging Markets Index managed a -1.0% return.

Long and unpredictable periods of underperformance (when tracking0error regret will rear its ugly head) are why I believe that, while it’s OK to “sin” (have more than a market-cap weighting to an asset class), it’s best for most people to sin only a little. And make sure you understand fully the nature of the risks you are taking, and be prepared to live with the consequences of your decisions.

This warning—to “sin only a little”—also applies to our next opportunity for increasing expected returns. The academic research has provided investors with strong evidence that there’s a small group of factors (sources of returns) that have provided higher returns. To be considered in this group, the evidence must have the following characteristics:

  • Persistence—it must hold across long periods of time and various economic regimes.
  • Pervasive—it must hold across countries, regions, sectors and even asset classes.
  • Robust—it must hold for various definitions (for instance, there’s a value premium whether we measure value by price-to-book, earnings, cash flow or sales).
  • Investable—it must hold up not just on paper, but also after considering trading costs.
  • Intuitive—there must be logical risk-based (economic) or behavioral-based explanations for the premium and why it should continue to exist.
  • It must not be subsumed by other well-known factors.

While there have been more than 300 investment factors identified—so many that John Cochrane called the situation a “factor zoo”—there are only a handful that meet these six criteria.

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