Which investing risk factors are important?

Which risk factors are important?

Investors in traditional index funds are effectively buying entire markets, simply capturing market returns, sometimes known as beta. But there's compelling evidence that by exposing their portfolios to specific risk factors, investors can and do beat the market over the long term. The question is: which factors actually matter?

In this video, Larry Swedroe, a leading authority on factor investing, explains what factors really are. A factor is nothing more than a characteristic, a trait or a style of investing that can be expressed across asset classes. Value, for instance, means buying what's cheap, whether in stocks, bonds, commodities or even currencies. The problem for investors today is that academic literature has now identified more than 600 factors, so many that John Cochrane famously called it a "zoo of factors." How is any investor supposed to know which ones are worth backing?

You'll learn how Swedroe, together with Andrew Berkin in their book "Your Complete Guide to Factor-Based Investing", set out to answer exactly that. They applied strict criteria: factors needed to be robust and persistent over time, and pervasive across different geographical regions. Drawing on 106 academic papers, they found just eight that met every requirement: market beta, size (small-cap stocks outperforming over the long term), value, momentum, profitability, quality, the carry trade, and the term premium. Everything else they discarded.

You'll also learn what happens as factor investing becomes more popular. Size and value funds, in particular, have attracted huge inflows. Does that cause the premiums to vanish? The research suggests that while many identified factors do shrink, on average they diminish by around a third rather than disappearing entirely. As money flows in and pushes up the prices of cheap stocks while pushing down overvalued ones, the spread narrows and the premium shrinks accordingly.

The takeaway: this is a big and complex subject, and you don't need to master every detail. The most important equity risk factors are size and value, and they do tend to outperform over the long term. But factor investors can go many years without seeing any benefit over traditional indexing. Patience, above all, is essential.

Chapters / Key points

• What traditional index investing captures (beta)
• What factor investing actually is
• Why factors can be applied across asset classes
• The "zoo" of over 600 identified factors
• How Swedroe and Berkin narrowed the field
• The criteria: robust, persistent and pervasive
• The eight factors that passed every test
• Why size and value are the most important equity factors
• Whether factor premiums disappear as money flows in
• Why factor investors need real patience

Transcript

Which risk factors are important?

Robin Powell: 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.

Larry Swedroe: Factors are nothing more than a characteristic, a trait 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?

Robin Powell: In a book co-written with Andrew Berkin, called "Your Complete Guide to Factor-Based Investing", Larry Swedroe reveals what 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.

Larry Swedroe: The ones that we looked at that passed all of our criteria, and we present the evidence from the academic literature, we cited 106 papers, are: market beta, obviously; size, meaning that 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 threw out the rest.

Robin Powell: 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?

Larry Swedroe: 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 a third. So, money does come in, and if you buy the cheap stocks, you push their prices up, and you push down the overvalued stocks by shorting or avoiding them, if you will. The spread between them narrows, and then the premium obviously would shrink.

Robin Powell: 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.