Theory & Strategy Factor Investing: A Post-Modern Portfolio Theory With apologies to Harry Markowitz, it’s wise to tweak MPT by seeking types of securities with factors that research shows ofer positive return premiums over time By JOHN BLOOD · Illustrations by ROBERT CARTER ince Harry Markowitz published his idea still forms the basis of modern portfolios. Journal of Finance paper creating Modern Beyond strategic asset allocation, though, many if not Portfolio Theory in 1952, asset allocation, most asset managers embrace various strategies beyond risk management and diversification MPT in an attempt to enhance their portfolio performance have become the governing principles for in some way, typically seeking to increase returns, reduce Sportfolio construction. Ask most financial advisors how downside risk or some combination of the two. These they create a portfolio, and the first thing they’ll reference investment approaches — which include actively managed is “MPT.” They seek out assets that are not correlated, so stock selection, dynamic or tactical asset allocation, and gains in one will offset losses in another. They work with the use of alternative investments, among others — are Harry Markowitz clients to trade risks for rewards, and seek out that ideal a core tool for the majority of advisors and investment Eugene Fama balance on an efficient frontier. Even now, after decades managers. Alas, any rigorous academic evidence that of tremendous market growth and shocks, Markowitz’s these strategies are actually effective is elusive. 40'INVESTMENT ADVISOR SEPTEMBER 2016 | ThinkAdvisor.com SEPTEMBER 2016 INVESTMENT ADVISOR'41 Theory & Strategy In fact, the majority of academ- ic research suggests that approaches like the ones mentioned previously — Factor Investing Explained despite their noble objectives — have How do you build a winning portfolio? Investment the exact opposite effect on portfolio managers use techniques such as fundamental outcomes. They tend to elevate portfo- analysis, technical analysis, even social media lio volatility, increase costs, reduce tax analysis. They work hard to identify the “best” efficiency and cause portfolios to under- securities and to diversify by sector, capitalization perform a strategic, low-cost, passively and country. But under the rigors of academic oriented approach. research and analysis, those strategies have his- Recognizing the power of this aca- torically failed to live up to expectations. demic evidence, some asset manag- The closest anyone has come thus far to catch- Kenneth French ers, my firm included, have evolved ing the performance genie in a bottle has been their portfolio construction approach. factor analysis, which uses academic research to We have created “post-modern port- quantify the components of “alpha” (an asset’s outperformance compared to the folios,” which tweak the idea of asset market overall) and turn it into an objective, repeatable model of security selection. allocation and diversification by seek- Since the 1960s, the traditional asset pricing model has been capital asset pricing ing out types of securities that have (CAPM), which uses a single variable (an asset’s beta, or correlation to the broad mar- been shown, by decades of academic ket) as a predictor of its expected future performance relative to some risk-free rate. research, to offer positive return pre- Then, in 1980, Rolf Banz, a former student of Eugene Fama, published a study find- miums over time. We are not talking ing that small-cap stocks had systematically outperformed large-cap stocks over time, about tech stocks here, nor biotech research that resulted in the founding of Dimensional Fund Advisors (DFA) and the 1981 or other high-profile, go-go indus- launch of its pioneering DFA 9-10 fund, which focused on small- and micro-cap stocks. tries. Instead, we are looking at certain In 1992, Eugene Fama and Kenneth French, professors at the University of investment characteristics — or “fac- Chicago Booth School of Business, expanded on Banz’s work and published “The tors” — that have been suggested by Cross Section of Expected Stock Returns,” expanding the single-factor CAPM into research to systematically offer posi- a three-factor model for analyzing security performance. To this day, this is per- tive return premiums to investors over haps the most widely cited paper in financial economics. long periods of time. FACTOR THIS Factor Investing = Dissecting Factors are observable and quantifiable security-level characteristics that can Alpha explain differences in stock returns. Fama and French’s three-factor model iden- In the 1960s, Nobel Laureate Eugene tifies three characteristics that predict a stock’s performance: beta, or overall Fama’s research showed that a portfolio market risk; size, with smaller companies throwing off higher returns than larger of selected stocks won’t typically beat companies; and value, measured as a security’s price-to-book ratio, with low-ratio the broad market index. Factor research stocks outperforming high-ratio stocks. looks further, dissecting alpha to under- In 1997, economist Mark Carhart posited a momentum factor (the tendency stand the elements of successful stock for a stock price to continue rising if it is going up and to continue declining if it is picking. It turned out that outperform- going down). More recently, Robert Novy-Marx (2012) and Fama/French (2015) ing stocks share certain traits, which have described additional factors, including profitability (stocks with a high operat- were given the name factors (see “Factor ing profits tend to outperform) and investment (companies that invest aggressive- Investing Explained,” right). ly in their business are more likely to outperform those that invest conservatively). There are literally hundreds of Numerous economists have demonstrated that, over the long term, returns of potential factors that have been an equity portfolio can be explained almost entirely through a factor lens. identified, but academic research has Columbia University finance professor Andrew Ang, author of “Asset helped narrow the field by identifying Management: A Systematic Approach to Factor Investing,” uses an insightful anal- those that seem to have the greatest ogy: Factors are to investment assets as nutrients are to food. Much as we eat probability of minimizing risk while foods for their underlying nutrients, to the quantitative investment manager it is maximizing returns. investment factors that really matter, not the assets themselves. Just as foods are Based on this research and our own bundles of nutrients, securities are bundles of factors. experience with factor investing, we 42'INVESTMENT ADVISOR SEPTEMBER 2016 | ThinkAdvisor.com Theory & Strategy Historical Performance of Factor Premiums Over Rolling Periods U.S. Markets Overlapping Periods: January 1928–December 2015 Overlapping Periods: January 1928–December 2015 MARKET beat T-BILLS VALUE beat GROWTH 15-Year 96% of the time 15-Year 97% of the time 10-Year 85% of the time 10-Year 88% of the time 5-Year 78% of the time 5-Year 77% of the time 1-Year 69% of the time 1-Year 61% of the time ‘Market’ is Fama/French Total U.S. Market Index. ‘T-Bills’ is One- Value is Fama/French U.S. Value Index. ‘Growth’ is Fama/French Month U.S. Treasury Bills. There are 877 overlapping 15-year U.S. Growth Index. There are 877 overlapping 15-year periods, 937 periods, 937 overlapping 10-year periods, 997 overlapping 5-year overlapping 10-year periods, 997 overlapping 5-year periods and periods and 1,045 overlapping 1-year periods. 1,045 overlapping 1-year periods. Overlapping Periods: January 1928–December 2015 Overlapping Periods: July 1963–December 2015 SMALL beat LARGE HIGH PROFITABILITY1 beat LOW PROFITABILITY 15-Year 82% of the time 15-Year 100% of the time 10-Year 72% of the time 10-Year 100% of the time 5-Year 64% of the time 5-Year 92% of the time 1-Year 57% of the time 1-Year 71% of the time ‘Small’ is Dimensional U.S. Small-Cap Index. ‘Large’ is S&P 500 ‘High’ is Dimensional U.S. High Profitability Index. ‘Low’ is Index. There are 877 overlapping 15-year periods, 937 overlapping Dimensional U.S. Low Profitability Index. There are 451 overlapping 10-year periods, 997 overlapping 5-year periods and 1,045 15-year periods, 511 overlapping 10-year periods, 571 overlapping overlapping 1-year periods. 5-year periods and 619 overlapping 1-year periods. Source: Dimensional Fund Advisors LP. Profitability is a measure of current profitability, based on information from individual companies’ income statements, in U.S. dollars, and based on rolling annualized returns using monthly data. Rolling multiyear periods overlap and are not independent. This statistical dependence must be considered when assessing the reliability of long-horizon return diferences. Dimensional Index data compiled by Dimensional. Fama/French data provided by Fama/French. The S&P data is provided by Standard & Poor’s Index Services Group. Eugene Fama and Ken French are members of the Board of Directors for and provide consulting services to Dimensional Fund Advisors LP. Index descriptions available upon request. have focused on these four factors that we believe to be most to remain stable, changing in value at a steady pace influential: over time 1. Size: The propensity for small-cap stocks to outperform 2. Dividend Yield: The tendency for companies who pay large-cap stocks over time steadily growing dividends (relative to their share price) 2. Relative Price: The tendency for value stocks to outper- to outperform the market over time. This is highly corre- form growth stocks over time lated with the “Relative Price” or “Value” factor. 3. Quality: The propensity for companies with higher prof- Instead of focusing at the asset class or individual security itability ratios to outperform those with lower-profitabil- level to create a diversified portfolio of stocks, bonds, cash and ity ratios over time alternatives, factor investing takes a more holistic approach to 4.