Does factor investing work?

Does factor investing work?

Does factor investing actually work, and could it help you beat the market? Broadly speaking, there are three types of fund you can invest in: passive funds that track a whole market, 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 generally not worth paying for, which is why many investors choose low-cost index funds instead. But for those willing to accept more volatility, there is a genuine case for using factor funds to try to earn higher long-term returns.

In this video, Gerard O'Reilly of Dimensional Fund Advisors explains what factor investing is and how to approach it sensibly. He starts with why we invest at all: we save and forego consumption today so we can grow our wealth ahead of inflation and consume more in the future. If you can raise a portfolio's expected return, you can either save less now for the same future lifestyle, or enjoy a better future for the same sacrifices today. That is the promise factor investing tries to deliver.

You'll learn why the approach has to be handled with care. There are literally hundreds of risk factors to choose from, and pursuing them carelessly can leave you with a portfolio that is less diversified, higher turnover and more expensive than simply owning the market. O'Reilly explains how Dimensional targets the main premiums (size, value and profitability) in a highly diversified, low-turnover, cost-efficient way, so that investors can expect to consume more in future than they would by holding the market alone.

He also explains how to decide which factors are worth pursuing: each new variable must genuinely improve your understanding of why expected returns differ across stocks, and allow you to build a better portfolio. Dimensional added these premiums methodically over decades, starting with small-cap in the 1980s, adding value in the 1990s, and profitability in the late 2000s, each one strengthening the portfolio without sacrificing diversification.

The takeaway: investing passively in the whole market is an excellent option. But if you want to try to beat it, you need disciplined exposure to the right factors, principally size, value and profitability. There are no guarantees, but with patience and discipline, that approach should give you a reasonable chance of outperforming the market over the long term.

Chapters / Key points

• The three main types of fund: passive, active and factor
• Why actively managed funds are generally not worth paying for
• What factor investing is and who it suits
• Why we invest: foregoing consumption today for more tomorrow
• How higher expected returns let you save less or enjoy more later
• Why hundreds of factors make a careful, methodical approach essential
• How to pursue premiums without losing diversification or raising costs
• Which factors matter most: size, value and profitability
• How Dimensional added factors methodically over decades
• Why patience and discipline are essential to factor investing

Transcript

Does factor investing work?

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 turnover, 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-turnover 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 drives differences in expected returns and enabled us to build diversified, so no loss of diversification, no increase in portfolio turnover, but better, more reliable portfolios as you added a new premium.

RP: In summary, investing passively in the whole market is a very good option. 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.