In In this article, we address the question of what factor investing is, which factors have produced particularly high returns in the past and what are the main advantages and disadvantages of this investment strategy.
1 What is factor investing?
Factor-based investing, smart beta investing or whatever factor investing is an investment strategy that focuses on securities with certain characteristics (so-called factors). These factors have historically provided investors with higher returns. This is confirmed by numerous scientific studies, which are often based on investigation periods of several decades.
So that’s what factor investing is Overweight factor premiums in a portfolio versus a market neutral weighting. The market-neutral weighting reflects the overall market or “all” stocks according to their market capitalization. It is the classic or the archetype of all passive investment strategies.
2 When is a factor premium involved?
Financial book author Larry Swedroe and other experts have the following seven criteria identified:
- Confirmation from at least a few dozen of each other independent scientists
- High durabilityi.e. over several decades (the more evenly distributed the factor premium, the more convincing)
- Global traceabilityie not focused on specific countries or sectors
- Unique filter criterionie no adjustments in the definition of the factor premium
- Cost-effective exploitation the factor premium, ie a factor premium should also result after costs
- traceabilityie it is based on a logically plausible explanation
- uniqueness the factor premium, ie not a mere variation of an already existing factor premium
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Gerd Kommer also mentions the following properties of factor premiums in his ETF standard work, which is well worth reading, “Souverän Investieren mit Indexfonds und ETFs”:
- Factor premiums can fluctuate widely and cannot be reliably forecast in the short or medium term.
- Factor premiums are not “additive”: it is therefore not possible to add up the sum of all individual factor premiums in a multi-factor portfolio.
- Most factor premiums become weaker after their scientific discovery, but often still high enough to result in excess returns after costs.
- Factor investing incurs higher costs than comparable simple ETFs.
- Factor investing only works statistically or according to the law of large numbers and not on the basis of individual values.
- Factor investing is compatible with Efficient Market Theory (EMT).
- Factor investing can be described as a “more active” variant of “passive” investing. The key characteristics of Passive, such as cost minimization, buy-and-hold, strict scientific orientation, mechanical rules-based and rigorous avoidance of conflicts of interest, still apply.
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3 The most important factor premiums in equities
In the following, the scientifically best proven five factor premiums of the asset class “Equities” are presented. For illustration, reference is made to the corresponding factor specific MSCI index referenced and the price development of the last 15 years compared to a more market-neutral index, usually the MSCI World, as a benchmark. The scientifically confirmed excess returns of the individual factors are discussed in Chapter 4.
3.1 Small-Size Premium
The small-size effect states that small stock corporations (second-line stocks) have statistically higher returns than large ones. The market capitalization or stock market value of a company serves as the basis for calculation. The index manufacturer MSCI defines the size relationships as follows: The largest companies, which make up 70% of the market capitalization of an index region, belong to the large caps. The next 15% are mid caps. Small caps follow for another 14%, while the remaining 1% is distributed among micro caps. The median stock market value of a small cap according to the “MSCI World Small Cap” index was around USD 853 million in August 2020.
In other words: only those who have more than 14% small caps in their portfolio can speak of a factor-based investment. Because 14% corresponds to the market-neutral weighting.
Largest position in “MSCI World Small Cap Index” as of August 31, 2020: Horizon Therapeutics
3.2 Value Premium
Value stocks in a scientific context (rather than stock picking à la Warren Buffett) have a particularly low share price relative to their fundamentals. This undervaluation is typically determined using the price-to-book (P/B) ratio, price-to-earnings (P/E) ratio, dividend yield, and free cash flow.
Largest position in “MSCI World Value” as of August 31, 2020: Johnson&Johnson
3.3 Momentum Premium
Stocks that have outperformed the market in the past also show higher returns in the near future. Put simply, this is the basic reasoning behind the momentum premium. It is therefore based on relative returns and, according to the “MSCI World Momentum Index”, includes stocks that have outperformed over the last 6 and 12 months.
Largest position in “MSCI World Momentum” as of August 31, 2020: Apple
3.4 Quality Premium
Quality stocks feature low levels of debt, stable earnings, steady asset growth, and strong corporate governance. So these are high-quality stocks based on common financial metrics like return-on-equity (ROE), debt-to-equity (D/E), and earnings variability.
Largest position in “MSCI World Quality” as of August 31, 2020: Apple (yet again)
3.5 Political Risk Premium
This factor premium relates to equities from the emerging markets or developing countries. It is essentially explained by compensation for a higher risk resulting from, among other things, political instability, corruption or an inadequate legal system or lack of separation of powers.
Largest position in “MSCI Emerging Markets” as of August 31, 2020: Alibaba
4 How do the five factors perform?
The single, but weighty benefit of factor investing is that excess return. From a (very) long-term perspective and to varying degrees, this also applies to our five factors described above. The table below shows the excess return per factor and during different time periods.
The following interesting aspects stand out in Figure 6:
- Value and small-size have been the most thoroughly researched scientifically and over the longest periods of time.
- The fluctuations are sometimes considerable. Political risk stocks underperformed by 0.3% between 2009 and 2018, while a decade earlier they had outperformed an incredible 12.8% a year.
- The little-known momentum premium is by far the most attractive at 4.3% over 24 years. On the other end of the spectrum, the much better-known value factor achieved a paltry 0.1% excess return.
5 What are the disadvantages of factor investing?
But before you decide on factor investing, you should also know about the main disadvantages.
All five factors listed above have the following disadvantages:
- Higher cost (TER), even if prices have fallen sharply in recent years
- Small product range or relatively few factor ETFs
- Longer yield dry spells than with a market-neutral investment requires an increased level of endurance and perseverance
In addition, the following aspects have a negative impact on the value factor
We summarize our conclusions as follows five points together:
- Factor investing can lead to excess returns in the long term and is generally worth checking, but it is not a must.
- A simpler and cheaper alternative to factor investing is and remains an investment in the overall market.
- We prefer the small-size, political risk, momentum and quality factors to the value strategy. According to the video below by Gerd Kommer Invest, “Value” is not dead yet, and a comeback may even be imminent. However, for tax reasons (for Swiss investors) it is not an issue for us. In addition, the dry spell in terms of the lack of excess returns is a bit too long for us.
- The range of factor ETFs is relatively small and the prices are higher than for “normal” ETFs. As an investor, you should consider these aspects.
- The excess returns for the five factors examined have been scientifically confirmed by numerous studies and over long periods of time. However, there is no guarantee that this will also apply in the future. In any case, you have to be prepared for long dry spells with factor investing.
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7 Further information
Informative video on factor investing by Gerd Kommer Invest
Standard work on passive investing with ETFs by Gerd Kommer with in-depth treatment of the topic “Factor Investing”:
More blog posts on the topic:
Learn to invest – in eight lessons
Buy ETFs – It’s that easy