Yellowstone Financial, Inc.

Building Wealth with Factor Investing

If you are at least a casual reader of the financial press, you’ve probably encountered the term “factor investing.” Factor investing rather than being a mere financial fad is one that stands on firm academic ground.  In the right hands it could be used to boost risk-adjusted investment returns.

Plainly stated factor investing is designing an investment portfolio made up of mutual funds, ETFs, and retirement plan options by emphasizing certain attributes.  These attributes, or factors, range from the well-known such as market risk to the more obscure, such as quality or momentum.

The market factor, also known as the equity premium or beta, is one factor you’re already using.  We expect that the stock market over the long term will generate higher returns than risk-free Treasury bills.  Since 1926, the average equity premium is 6.6 percent per year.  We know that the extra return is not “free.”  You must accept much more year to year volatility with stocks than Treasury bills in order to expect the higher returns

The second factor is the size of the companies you invest in as valued by the market.  On average small company stocks, those valued at under $1 billion, have earned an extra 2.2 percent annually in the US when compared to large companies.  Like the first factor, the performance of small company stocks is more volatile.

The value factor refers to the price of a company compared to its accounting value (also known as book value).  The cheapest 30 percent of stocks are known as value stocks, while the expensive ones are growth stocks.  With this concept we’re not talking about the stock price, but instead the market value of an entire company.  Value stocks since 1926 have appreciated on average 3.3 percent a year more than growth stocks.   As with the previous factors, value stocks tend to be more volatile on an annual basis than the total stock market.

Two additional factors have been more recently featured: profitability and momentum.  The profitability (also known as quality) factor emphasizes companies that have higher earnings in comparison to its book value.  The data are harder to get at here, but by one measure profitable companies have had an average annual return of 4 percent higher than relatively unprofitable companies since 1964.

Momentum is the idea that certain segments of the market when they perform relatively better than their peers will tend to persist in their outperformance in the following quarters.  While academics have shown that this is a persistent phenomenon, it is challenging to efficiently design portfolios to take advantage of momentum.

One issue with these factors is that while average annual returns may be higher, you can go through long periods in which the factors do not work.  Over ten year periods since 1926 — a long investment horizon for many — T bills have beaten stocks 15 percent of the time, large companies topped small companies 27 percent of the time, and growth stocks have beaten value 17 percent of periods.  Most investors will abandon strategies that are not working over ten years, which is perhaps the biggest challenge of factor investing.

There is additional complexity with factor investing.  To pull it off, you need to be good at designing portfolios and have the stomach for significant deviation from broader market returns.  There will be extended periods when it will seem that it is not working.  We’re in such a time now as over the last ten years, the value and profitability premiums have been negative.

If you’re interested in factor investing, look first for low cost diversified mutual funds that emphasize value and small company stocks, while keeping exposure to the broader market for diversification purposes.  Charles Schwab introduced relatively low-cost fundamental index ETFs in 2013 that moderately emphasize small and value companies, without having to have to own several different funds.