RP: Broadly speaking there are three different types of fund you can invest in — passive funds, active funds, and funds that give you exposure to specific factors, sometimes known as factor funds. The evidence is clear that actively managed funds are not worth paying for. Many investors choose instead to invest entirely in passively managed index funds that track an entire market. But, for those who are willing to accept more volatility, there is a case for trying to beat the market using factor funds. Here is Gerard O’Reilly from Dimensional Fund Advisors.
GO’R: What do investors do? Investors save, so they forego consumption today, to grow their wealth in excess of inflation so they can consume more tomorrow. That’s why most people save, they save for retirement or consumption in the future. And by consuming less today, more in the future.
If you can increase the expected return of a portfolio there’s two things that you can do with that: You can lower the amount that they have to save today to afford a similar level of consumption in the future. Or you can have them afford more in the future so they can live an even better life in the future for making sacrifices today.
RP: The problem is there are literally hundreds of risk factors to choose from. It’s very important, if you take the factor investing route, to go about it in a careful and methodical way.
GO’R: Because the market is a good portfolio to own, as you go about increasing expected returns by pursuing size, value and profitability premiums, you don’t want to end up with a portfolio that’s inferior to the market, that's a lot less diversified, that has much higher turn-over, that has much higher costs.
And what we’ve been able to do at Dimensional is to pursue those premiums in a very diversified, very cost-efficient, very low turn-over way so that people, on expectation, can afford to consume more in the future by investing in funds and so on that pursue these premiums than they would by just investing in the market.
RP: So, how many different factors should you seek exposure to? And crucially, which ones?
GO’R: You really have to examine what each new variable brings to the table. Does it improve your understanding of expected returns? And, in particular, differences in expected returns across stocks? And does that enhanced understanding allow you to build a better portfolio? And, so, that is case by case.
So, as an example Dimensional started off with small-cap portfolios back in the early 80s, added value in the 90s and then in the late 2000s and early 2010s added profitability. Each one of those enhanced our understanding of what drive differences in expected returns and enabled us to build diversified - so no loss of diversifications, no increase in portfolio turn-over - but better, more reliable portfolios as you added a new premium.
RP: In summary, investing passively in the whole market is a very good opposition. If you want to try to beat the market you need exposure to different factors - principally size, value and profitability. There’s no guarantee, but if you’re patient and disciplined, that should enable you to outperform the market over the long term.
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