RP: Hello there. Investors in traditional index funds are effectively investing in entire markets. They’re simply capturing market returns, sometimes known as beta. But there’s evidence to show that by exposing their portfolios to specific risk factors, investors can and do beat the market over the long term.
A leading authority on so-called factor investing is Larry Swedroe.
LS: Factors are nothing more than a characteristic, a trade or a style of investing that can be expressed even across asset classes. So, you could buy value, which is buying what’s cheap in stocks, bonds, commodities or even currencies. The problem for investors today is, that in the academic literature, over 600 factors have been discovered, so many, that John Cochrane called it a zoo of factors. So, how is an investor to know which of the 600 are worth investing in?
RP: In a book co-written with Andrew Berkin, called "Your Complete Guide to Factor-Based Investing", Larry Swedroe reveals which the most important factors are. The authors set out different criteria.
Factors needed to be robust and persistent over time, for example. They also had to be pervasive across different geographical regions. They actually found just eight factors that met all the relevant criteria.
LS: The ones that we looked at that passed all of our criteria - and we present the evidence from the academic literature, we sited 106 papers - are: market-beta - obviously, size - meaning the small-cap stocks outperform over the long-term, value, momentum, profitability and quality, something that’s called the “carry trade” and last is the term-premium. We trough out the rest.
RP: This is a big and complex subject, which you don’t need to know about in any great detail. Suffice it to say, the most important equity risk factors are size and value. Certainly, size and value funds have become increasingly popular. So, is that a problem for factor investors? In other words, do the premiums start to disappear as more people choose to gain exposure to them?
LS: There’s actually pretty good literature now on this, that for the factors that have been identified, many of them do disappear but on average they shrink about 1/3. So, money does come in and if you buy the cheap stocks, you push their prices up you push down by shortening or avoiding the overvalued stocks if you will. The spread between them narrows and then the premium obviously would shrink.
RP: One final word of caution. Yes, factors such as size and value do tend to outperform over the long term. But factor investors can go for many years without seeing any benefit over and above traditional indexing. So you do need to be patient. Thanks for watching. Goodbye.
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