Does Factor-Based Investing Work?
October 24, 2016

Does Factor-Based Investing Work?

Last summer I watched Creed. It’s the latest movie in the “Rocky Balboa” series. One of the lines stands out. The movie’s lead character, Adonis Creed, asked Rocky how he had beaten his father. “I didn’t beat your father,” said Rocky. “Time takes everybody out. Time’s undefeated.”

It’s like that for most investors who try to beat the market. They might get lucky for a year or a decade. But if a low-cost index fund were a boxer, time would stand in its corner. According to the SPIVA scorecard, the S&P Composite 1500 Index beat 87.47 percent of U.S. actively managed stock funds during the ten years ending June 30, 2016.

Funds that win during one time period often get bruised the next. The SPIVA Persistence Scorecard tracks top performing mutual funds. It finds out whether the highest performing funds can continue to win. According to the January 2016 report, “Out of 678 domestic equity funds that were in the top quartile [of performers] as of September 2013, only 4.28 percent managed to stay in the top quartile by the end of September 2015.”

Hedge funds don’t perform any better. In fact, they do worse.

But plenty of investment firms (and their marketers) say they’ve found a secret sauce. It’s called Factor-Based investing. Factor-based funds include specific types of stocks. For example, value stocks are a type of factor. Such stocks are cheap. They have also proven to beat the market over time.

Size is another factor. If we lump small-cap stocks into a single fund, we’re betting that the size factor will work. Studies show that small-cap stocks have also beaten the broad market.

Then there are popular stocks that have risen a lot in price. If we stuff these stocks into a single fund we would be trying to use the momentum factor. Do you remember studying inertia in your middle school science class? An object in motion will stay in motion unless an opposite force acts against it. It’s the same with momentum stocks.

Can we beat the market if we buy these funds? Larry Swedroe says we might. You can find the research in his latest book Your Complete Guide To Factor-Based Investing.

Swedroe’s book dives into different factors. He puts them through some rigorous tests. For example, he wanted to see if they each had a long history of beating the market. He also wanted to see if they would have won in different countries.

After testing other scenarios, he focused his attention on factor-based funds that investors can actually buy. Did they perform like they were supposed to?

He found that they did. But not every factor wins during every time period. That’s why Swedroe says investors should build portfolios that represent different factors. Those that win during one time period often lose the next. He says that diversifying across different factors can lead to strong risk-adjusted returns. He measured the odds of different investment factors outperforming the market between 1927 and 2015. I included each of them in the table below.

For example, he says there's a 63 percent chance that value stocks would beat the market over a one-year period. The odds increase to 72 percent over 3-year periods. Over 20-year periods, there's a 94 percent chance that value stocks would beat a total stock market index.

It looks even better when we bring different factors together. Swedroe looked at 3 different portfolio allocations (see P1, P2 and P3 on the table). Their odds of beating the market were higher than with any single factor.

He writes, “Portfolio 1 (P1) is allocated 25 percent to each of four factors: market beta, size, value, and momentum. Portfolio 2 (P2) is allocated 20 percent to each of the same four factors plus a 20 percent allocation to the profitability factor. Portfolio 3 (P3) is allocated the same way as P2, substituting the quality factor for the profitability factor.”

Odds Of Factors Outperforming The Market

Factor 1-Year 3-Year 5-Year 10-Year 20-Year
Value 63% 72% 82% 90% 94%
Market Beta 66% 76% 82% 90% 96%
Size 59% 76% 70% 77% 86%
Momentum 77% 86% 91% 97% 100%
Profitability 63% 72% 77% 85% 93%
Quality 65% 75% 81% 89% 96%
Theoretical Factor-Based Portfolios 1-Year 3-Year 5-Year 10-Year 20-Year
P1 77% 90% 95% 99% 100%
P2 83% 95% 98% 100% 100%
P3 77% 97% 99% 100% 100%

Popularity, however, could knock the advantage down, so Larry Swedroe addressed that. He wanted to see if each factor’s success continued after its promise was made public. Based on his findings, the factors didn’t do as well. But they still beat the market.

However, if factor-based investing takes on a pop-culture appeal, it might stop performing. Such stocks could become more expensive. Returns might suffer. If that happens, traditional broad index funds might win. It’s worth remembering Rocky’s quote.

“Time takes everybody out. Time’s undefeated.”

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This article contains the opinions of the author but not necessarily the opinions of AssetBuilder Inc. The opinion of the author is subject to change without notice. All materials presented are compiled from sources believed to be reliable and current, but accuracy cannot be guaranteed. This article is distributed for educational purposes, and it is not to be construed as an offer, solicitation, recommendation, or endorsement of any particular security, product, or service.

Performance data shown represents past performance. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown.

AssetBuilder Inc. is an investment advisor registered with the Securities and Exchange Commission. Consider the investment objectives, risks, and expenses carefully before investing.